AJAX MANUFACTURING COMPANY

Ajax manufactures three different products for an industrial market. This production
constitutes a full line in the simplified context. The cost accounting system used by Ajax
is a traditional one in the sense that is very much like the system literally thousands of
firms have used for many years.

Sales prices and sales volume data for the three products are shown in Exhibit 1 along
with basic production and standard cost statistics. Target sales prices reflect the prices
needed to achieve the planned 35% gross margin, given the product costs generated by
the accounting system. The product costs are calculated as follows.

1. Charge each product for raw material cost (the sum of purchased components times
the purchase price).

2. Charge each product for direct labor cost (labor hours per unit times the labor charge
per hour)

3. Assign overhead costs to units based on a two-stage allocation formula. Stage one is
to assign the costs of overhead departments to production departments based on some
relevant measure of activity (square feet of floor space for janitorial cost, machine
value for insurance cost, employee head count for personal cost, etc.). Then, after all
costs have been assigned to production departments, stage two is to assign costs to
units of product based on some measure of throughput or output volume in the
production departments. The most frequently used measure of production volume in
multiproduct plants traditionally has been labor dollars (of labor hours).

In our example, because there is only one production department (machines), the first
stage allocation is trivial. Because there is one production department, allocating all of
the indirect overhead to it must be correct. Yet even when the stage-one allocations are

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perfectly accurate, meaningful product costing is not assured. The false belief that
reasonableness of the allocations at stage one produces reasonable end unit costs is part of
the problem with volume-based costing.

Assuming set-up labor is included, the total overhead to be assigned to the production in
the machines department is shown in Exhibit 2. In a traditional costing system such as
this, overhead is assigned to products based on direct labor dollars. Using this
information, Ajax calculates the unit cost of products A, B, and C as shown in Exhibit 3.
Product profitability data is summarized in Exhibit 4.

As shown in Exhibit 4, product A is achieving its planned margin. Product B is

achieving only 31% gross margin because this product has come under heavy price
pressure from foreign competitors. Ajax knows its factory is as modern and efficient as
any in the world and thus is convinced that the foreign firms are dumping product B in
the US market. Ajax has dropped its price somewhat in response to the foreign firms, but
it is very reluctant to cut further because of the low achieved gross margin. Its sales
volume for product B has fallen substantially, although B is still the highest-volume
product.

Fortunately for Ajax, it has been able to offset the declining profits from B by
significantly raising the price of C. Ajax was pleasantly surprised when customers
readily accepted the price increases here. Also, even with the higher prices, competition
has not challenged Ajax very much for this business. The result seems to be a very
profitable low volume niche that competitors don’t invade. Management presumes that
product C must have some unique characteristics that are very attractive to customers but
that are not apparent to Ajax. Because of the market dominance it has achieved with C,
Ajax still should be earning its target overall gross margin of 35%. But actual results
consistently seem to lag the projected results. Management attributes the decline to
“inexplicable” overhead creep - lack of management discipline.

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Concern with costs and prices for its volume leader, product B, has led Ajax to
experiment with some modern refinements to its cost accounting system. The controller
has developed a new approach to product costing, even though top management has not
yet seen his calculations. Still using only the information in Exhibit 1, he has
incorporated three refinements to the traditional system. His modern touches are:

1. Breaking out set-up labor from the overhead pool and charging it to each product
based on set-up time per production run divided by the number of units in a
production run. For example, for product A, one set up costs $200 (10 hours x
$20/hour) and the run is 10,000 units. Set-up cost is thus 0.02 per unit ($200/10,000).
This refinement goes beyond averaging set-up cost across the products to specifically
identify it with the individual products. This refinement can be very important when
products differ in set-up time, number of production set ups, or in length of
production runs (or all three).

2. Breaking out the overhead that is more related to material cost (receiving or inbound
inspection, for example) and charging it to products based on material cost rather than
labor cost. Under this refinement a pool of material handling overhead is separate
from the pool of production overhead. Material handling overhead is charged to
products based on raw material dollars, rather than direct labor dollars. This
refinement can be very important when products differ in raw material content.

3. Substituting machine hours for labor dollars (or labor hours) as the measure of
production volume. As factories have become much less labor-paced and much more
machine-paced, the notion of labor content as the best measure of throughput has lost
its relevance. When one worker attends several machines that perform different
functions, run at different speeds, and differ in cost and complexity, labor cost loses
its meaning as a central element in product costing. The overhead rate of 757%
(overhead + direct labor) for Ajax is a clear signal that labor is no longer a dominant
cost component.

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In this case, direct labor cost is only 8% of total cost, a far cry from the factories of the
past or of textbook lore. When direct labor cost dropped to 3% of total cost in Hewlett-
Packard, management relegated it to another component of overhead in a two-component
cost system - material cost and overhead.

For Ajax, where the machines are ostensibly identical and machine-specific cost is three
times as high as direct labor cost, machine hours consumed can be viewed as a better
measure of throughput and thus as a superior basis for assigning indirect overhead.

Using these three refinements, the controller has calculated product cost using raw
material cost, direct labor cost, product-specific set-up cost, material handling overhead
charged in proportion to material cost, and production overhead charged in proportion to
machine hours consumed. Exhibit 5 shows the product costs of A, B, and C when
calculated using these refinements.

The controller is almost ready to present his modern cost accounting system ideas to top
management. He feels sure that this information will strengthen management’s resolve
not to cut prices on product B any further. The new system shows that margins are even
lower than management currently believes. The controller seems this as further evidence
that foreign firms must be dumping product B to Ajax customers. Part of his hesitation in
releasing the new cost data had been based on his concern about how management would
view the news that C is not as profitable as they had thought, even though A is much
more profitable. This concern had lessened recently when he heard the sales manager say
that Ajax was experimenting with 15% price jumps for C in some regions. Amazingly,
salespeople had found customers still willing to order normal quantities.

Questions
1. Do you think that there is anything wrong with the present cost system?
2. If Ajax was aware of Activity-Based Costing, do you think that it would have given a
dramatic different assessment of the opinion under consideration?

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 EXHIBIT 1
Basic Product Information

Three Products

A B C Total

Production 10,000 units 15,000 units 5,000 units in

in 1 run in 3 runs 10 runs
Shipments 10,000 units 15,000 units 5,000 units in
in 1 shipment in 5 shipments 20 shipments
Selling Prices
Target $162.61 $134.09 $81.31
Actual 162.61 125.96 105.70

MANUFACTURING COST

Law material 5 components 6 components 10 components

@ $4 ca. = @ $5 ca. = @ $1 ca. =
$20 $30 $10
Labor usage

Set-up labor 10 hours per 10 hours per 11 hours per 150 hours
production run production run production run

Run labor 1/2 hour per 1/3 hour per 1/4 hour per 11,250 hours
part part part

Machines 1/4 hour per 1/3 hour per 1/2 hr. per part
usage part part 10,000 hours.

OTHER OVERHEAD

Receiving department $ 300,000

Engineering department 500,000
Packing department 200,000
Note: There is only one production department - machines - and it takes a little more
than 1 labor hour for each machine hour (11,250/10,000) at the current product mix.
(Labor = $20 hr. including fringe benefits: machine cost = $70 hr.)


Again, the categories of manufacturing overhead have been greatly simplified for
purposes of this case.

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 EXHIBIT 2
Total Overhead Assigned to the Machines Department

Allocated overhead
Setup $3,000
Receiving 300,000
Engineering 500,000
Packing 200,000 $1,003,000
Directly assignable overhead
Machines cost 700.000
(10,000 hours x $70/hr.)
Total Overhead $1,703,000

EXHIBIT 3
The Traditional Approach to Calculating Unit Costs

A B C
Raw material $20.00 $30.00 $10.00
Direct labor 10.00 6.67 5.00
Overhead (labor $ basis) 75.70 50.49 37.85
Set up 3,000
Machines 700,000
Receiving 300,000
Engineering 500,000
Packing 200,000
Total $1,703,000 $105.70 $87.16 $52.85
Overhead rate = $ 1,703,000/$225,000=757%

EXHIBIT 4
Data on Product Profitability

A B C
Standard cost $105.70 $587.16 $52.85
Target selling price $162.61 $134.09 $81.31
Planned gross margin 35% 35% 35%
Actual selling price $162.61 $125.96 $105.70
Actual gross margin 35% 31% 50%

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 EXHIBIT 5
The Modern Approach

A B C

Raw Material $20.00 $30.00 $10.00

Material overhead
(Material $ basis), (300K/700K = 43%) 8.60 12.90 4.30
Set-up labor 0.02 0.04 0.44
Direct labor 10.00 6.67 5.00
Other Overhead
(Machines hours basis) 35.00 46.67 70.00
Machines $700,000
Engineering 500,000
Packing 200,000
$1,400,000

Total $73.62 $96.28 $89.74

Overhead rate = $ 1,400,000/10,000 = $140 hr.