5 Pages Posted: 14 Aug 2010 Last revised: 21 Oct 2010
Date Written: August 14, 2010
The Redmond Products instructional problem exposes pitfalls of traditional absorption product costing systems. It promotes a discussion of errors inherent treating manufacturing overhead costs as “indirect” costs that should be “allocated” to products using a predetermined manufacturing overhead rate.
The problem is appropriate for use in Managerial Accounting and Cost Accounting courses. The author uses it at the point in the course when he transitions from traditional absorption costing to activity-based costing (ABC). It can also be used by accountants and management consultants to concisely explain the nature and consequences of design flaws in traditional product costing systems to senior managers.
In the problem, the company manufactures Red and Blue products that are identical, except for their colors. The reported costs are $22.00 per unit for each product. One day, the Red product manager decides to lease a machine for $3,000,000 per month that would reduce direct labor costs by $3,000,000 per month. This cost-neutral decision has a significant impact on reported product costs: Red product unit costs decrease by more than 50% and Blue product (whose manager did nothing at all) costs increase by more than 50%.
Despite common practice regarding cost classification, not all manufacturing overhead costs are “indirect costs.” The monthly cost of the leased machine in this problem is a “direct cost” of producing the Red Sphere product - and only that product. Direct costs should be causally “assigned” to products, rather than arbitrarily “allocated” to products according to a simple formula, without regard to the consumption of resources used to manufacture individual products.
Since the leased machine is used to manufacture only the Red product, it should be treated as a “direct” cost of that product. Traditional absorption costing “allocates” only 20% ($600,000 per month) of the machine cost to the Red product – and 80% ($2,400,000) of the cost to the Blue product. This problem promotes a discussion of the perils of rampant and unexposed allocation errors that are inherent in the design of traditional absorption costing systems.
Keywords: Cost Management, Cost Accounting, Managerial Accounting, Activity-Based Costing (ABC)
JEL Classification: M49
Suggested Citation: Suggested Citation