Cost Accounting Case Study

Eileen Peacock

AACSB International

Paul Juras

Wake Forest University

“We invested a great deal of time and money into developing the

activity-based costing (ABC) system, and now I am not sure if it

provides the information we really need for long-term decision-

making purposes,” Amy Wesling, plant manager of Precision

Paint Shop’s (PPS) Southern Plant, told her administrative team.

“The ABC data helped us understand our costs better, but now

I’m wondering if it’s the right information to serve as the basis for

helping us achieve our strategic goals.”

COMPANY DESCRIPTION

Precision Paint Shop (a fictionalized version of an actual

Midwest company) is a privately-held custom coater

(painter) of automotive components for original equipment

manufacturers (OEMs) and tier 1 and tier 2 suppliers.

The company has annual revenues of $90 million per year,

with $35 million in sales from the Southern plant, which

specializes in spray topcoat applications.

PPS specializes in the application of a series of coatings.

Raw metal parts are received on consignment from the

customer, finished with the desired application(s) of paint

and other coatings, and shipped back to the same customer.

The product lines consist of a large number of combinations

of paint colors, types of coating, and paint finishes. Figure

1 provides a diagram of the production process, and “PPS’s

Production Process” (Sidebar 1) provides a narrative of the

production process.

Historically, PPS accepted most of the work assignments

offered. Prices were market driven, and management used

a form of standard costing to evaluate product profitability.

Over the past three years demand had significantly

increased, especially in the higher-grade coatings. In fact,

the product mix flip-flopped from 80% low-gloss (LG) finish

two years ago to 85% high-gloss (HG) finish in the current

year. Unfortunately, along with the increase in volume came

a decrease in profits.

The immense number of combinations of coatings and

color created complexity for the company. Also, the parts to

be painted varied in size and shape, further complicating the

painting process. The end result was that four characteristics—

coating, color, shape, and size—were instrumental in

determining the complexity of the operation. This variety

initiated a mix of activities unique to each job. The very

nature of the painting process and the need for a near-100%

perfection level in the industry resulted in a high level of

inspections, refinishing, rework, and scrap. Complexity had

driven up overhead costs, leaving direct materials accounting

for only 26% of total manufacturing costs.

THE COSTING SYSTEM

Recently had PPS moved away from a conventional standard

costing system to ABC. The change was made to better

understand the costs associated with painting the various

products. The ABC analysis revealed the fundamental

differences that existed between the different mixes of

product characteristics. Table 1 provides an illustrative

comparison of two versions of a bumper: an LG finish

and an HG finish. After the ABC analysis, Chad Leaders,

plant accountant, provided a report showing a significant

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ISSN 1940-204X

Alternative Costing Methods: Precision Paint Shop’s Dilemma

change in the reported profitability levels of the various

product lines. Table 2 summarizes the types of changes that

took place. Once implemented, the ABC information was

used to negotiate product pricing and to report financial

performance.

PLANNING FOR CAPACITY USE

The conveyor line was definitely a constraining resource of

the painting process. Through her knowledge of theory of

constraints (TOC), Mandy James, production supervisor,

had developed a method for factoring in the various process

elements into demand levels on conveyor capacity. Using

bumpers as an example, she presented the template

appearing in Table 3, and compared an LG bumper to an

HG bumper. The template starts with the quality issue.

The greater the percentage of defects, the lower the yield

rate (YR) for a production run. The more complex shapes

and finishes have lower yield rates than those that are less

complex. LG bumpers currently have a YR of about 95%,

while HG bumpers run about 92%.

Defective products can be worked on in-house, and

some can be recovered. For bumpers, the recovery rate

(RR) is about 5% of units started. Since the recovered

bumpers are brought up to an acceptable quality level, they

contribute toward meeting customer demand and put no

further demand on the conveyor capacity. The YR and RR

can be combined to determine how many products must be

processed to generate one unit of acceptable quality, which

is called the run factor (RF). The RF is equal to 1/(YR+RR).

If YR+RR=1, as with the LG bumper, then only one unit

must be put on the conveyor to ultimately yield one unit

of acceptable quality. The RF for the HG bumper is 103%

(computed as 1/(92% + 5%)), meaning PPS must paint 103%

of the total bumpers required to yield enough bumpers of

acceptable quality to satisfy customer demand.

Since the conveyor line is the constraint, the time a

product spends on the conveyor is an important issue. Line

speed can vary from 10 to 18 feet per minute, depending

on the size and shape of the product being painted. Mandy

considers 18 feet per minute to be the standard time unit

for the conveyor line. A complexity factor (CF) ranging

between 1 (for fastest line speed) and 1.8 (for slowest speed)

is determined for each product family and added to the

calculation of demand. The CF is computed by dividing

the standard line speed of 18 feet per minute by the line

speed required for the specific product, so a faster line speed

results in a CF closer to 1. The line speed of the HG bumper

is currently 12 feet per minute, resulting in an CF of 18/12

= 1.5. The CF is then multiplied by the RF to get the total

constraint demand factor (DF).

The DF is actually a demand placed on the conveyor per

unit of finished good of a particular part type. Because parts

can vary in shape and size, PPS needed a standard unit of

measure to compare product profitability that factored in the

total demand placed on the conveyor. The square footage

of each part was chosen as the measurement unit because

it represents the surface area of each part that’s coated. As

a result, the DF is divided by the total square footage of

a particular part (e.g., a bumper) to yield the bottleneck

demand factor (BDF), which is the demand factor per square

foot of a particular size, shape, and finish. The profit level

per square foot of finished good is divided by the BDF to

yield the profit per throughput unit (P/TU) on the conveyor.

Table 3 shows the LG bumper has a lower profit per unit

($10 per bumper, or $1 per sq. ft.), but after adjusting for the

respective demands on the conveyor, the LG bumper has a

higher P/TU.

DECISION POINT

Management of PPS used ABC to obtain a better

understanding of the “true” cost of the products in order

to help make better pricing decisions. Management now

wants to be more proactive in the use of costing information

to help develop and implement organizational strategy

in an environment where the demand exceeds current

productive capacity. Based on the opening question posed

by Amy, PPS’s management was attempting to move away

from merely trying to assign costs more accurately to using

the cost information to support strategic decision making.

Specifically, Amy wants to make strategic decisions about

which product lines to promote and pursue. She is aware of

the ABC process of assigning cost of resources to activities,

but considers this an operational rather than strategic

issue. She isn’t clear about whether ABC supports strategic

decision making.

Mandy pointed out that the conveyor line was being

fully utilized and jobs were being turned down because

of the capacity constraint. She thought the capacity issue

should drive any strategic decisions and that Amy should

adopt the principles of TOC and throughput costing for

strategic decision making. Mandy supported her position

with the following example. “HG bumpers are a big part

of production,” she said. “We evaluated whether or not

to increase the line speed when HG bumpers are being

painted. The increase in speed will reduce the yield rate

from 92% to 90%. There will be more defects, but the

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RR will increase to 6%, and, as Table 3 shows, the P/TU

will increase and the finesse costs per unit would actually

decline.” (See Sidebar 2, “Finessing.”)

Chad disagreed with Mandy’s recommendation. Using

Table 1, Chad noted that the HG finishes have higher

reject rates, require additional painters, more colors, more

inspections and maintenance costs, and slower line speed.

The HG products are also treated as they pass through

Stations 3 and 4. Since some of the costs related to resource

demands are fixed costs, throughput costing shouldn’t be

used because these fixed costs would be ignored. He offered

an alternative, resource consumption accounting (RCA),

which he had heard about at a recent local IMA chapter

meeting. He thought RCA might be what Amy needed, but

he wasn’t entirely sure. Chad presented Amy with a brief

description of the costing method. (See Sidebar 3, “Basics of

RCA.”) He offered to learn more about RCA by attending

a continuing education session offered by IMA, but Amy

wanted more information before making the investment in

having Chad attend the session.

SUGGESTED RESOURCES

Chwen, Sheu, Ming-Hsiang Chen, and Stacy Kovar.

“Integrating ABC and TOC for Better Manufacturing

Decision Making.” Integrated Manufacturing Systems, May

2003, pp. 433-441.

Grasso, Lawrence P. “Are ABC and RCA Accounting

Systems Compatible with Lean Management?”

Management Accounting Quarterly, Fall 2005, pp. 12-27.

Keys, David, and Anton van der Merwe. “Gaining Effective

Organizational Control with RCA.” Strategic Finance,

May 2002, pp. 41-47.

Resource Consumption Accounting Institute website,

http://www.rcainstitute.org

van der Merwe, Anton, and David Keys. “The Case for

Resource Consumption Accounting.” Strategic Finance,

April 2002, pp 31-36.

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ABOUT IMA With a worldwide network of nearly 60,000 professionals,

IMA is the world’s leading organization dedicated to

empowering accounting and finance professionals to drive

business performance. IMA provides a dynamic forum for

professionals to advance their careers through Certified

Management Accountant (CMA®) certification, research,

professional education, networking and advocacy of the

highest ethical and professional standards. For more

information about IMA, please visit www.imanet.org.

SIDEBAR 1: PPS’S PRODUCTION PROCESS

PPS operates two 8-hour shifts, 240 days per year. The paint

process involves a monorail conveyor line that moves at line

speeds of 10-18 feet per minute, depending on the application

and part complexity. The total paint cycle time is about 2.5

hours. The production schedule is created based on customer

requirements, line speed, minimum lot (or batch) size, and the

availability of racks. The material handlers bring the raw parts

and racks to the line and loaders rack each part, making sure

it is racked properly so that when it enters the E-coat tank a

proper electrical ground is attained.

THE PAINT PROCESS

The part is first treated with chemicals (pre-treatment

stage), a sequence of washing and rinsing to remove any

grease or dirt and to prepare the part for paint adhesion

with a phosphate spraying. Next, the part is submerged

in a 20,000-gallon e-coat tank. As it comes out of the tank,

it is sprayed with fresh, deionized water to rinse off any

“dragout” paint clinging to the parts, thereby eliminating

appearance defects. The part then moves through four paint

booths. Depending on the part type, however, all four booths

may not be used.

• Booth 1 has five automatic spray guns that apply primer.

A part may or may not receive a primer coating, which

provides additional protection against chipping and

rusting.

• Booth 2 has two manual sprayers as well as automatic

sprayers that paint basecoat or enamel topcoat.

• Booth 3 has one manual sprayer and an automatic spray

gun that apply clearcoat. Only high-gloss products receive

the glossy, shiny clearcoat finish.

• Booth 4 has two manual sprayers and automatic spray guns

that also apply clearcoat for parts that require two coats.

While low-gloss products are being painted, booth 3 and

booth 4 painters are idle and the spray guns are turned off. De-

pending on the product line, the part receives a basecoat (high

gloss) or an enamel topcoat (low gloss). After these processes,

the paint is cured in another oven. As the product arrives back

at the unload/load area, it is date-stamped, unracked onto a

floor conveyor, inspected, unloaded, and packaged.

THE SETUP PROCESS

A five-minute setup “gap” is required when changing paint

colors. This gives line workers the time to change the tooling

racks, modify the line speed, purge the line of the old paint,

and run the new paint through the system.

As the setup gap nears the paint booths, paint containers

with the required colors are transported to the paint booth.

While the last part from the prior color is painted, the paint

lines are quickly purged of the old paint, flushed with solvents

to clean the paint lines, and new paint is sprayed through the

spray guns to obtain the desired consistency. As the gap ends

and the raw parts appear, the painting begins again.

QUALITY ASSURANCE OR REWORK PROCESS

The primary sources of rejections are: dirt and dust in the

manual hand sprayers, old equipment, and the nature of

the industry. High-gloss products, which are much more

expensive to reprocess, have substantially higher rejection

rates than low-gloss products.

Rework mostly requires sanding. The product is sanded

down to the e-coat primer and then moved to the line for

reprocessing. Some products are sent to an outside stripper.

Some defects can be corrected by finessing, which elimi-

nates the need for complete reprocessing. Finessing allows

the defect to be buffed out on parts that have the clearcoat

glossy finish. Parts are considered “saved” when they can be

unloaded along with the other painted good parts.

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SIDEBAR 2: FINESSING

Currently PPS finesses approximately 100,000 bumpers per

year, or about 5% of bumpers run on the conveyor. If the line

speed is increased, the decline in the yield rate would create

about 20,000 additional bumpers that the finesse department

could work on. The finesse department can handle 125,000

units per year when operating at maximum efficiency, and

the variable costs for finesse are less than $0.02 per unit, so

the increase in units worked wouldn’t generate much change

in the total costs even though the computed cost per unit

does change. The table provides the supporting detail.

Finesse Cost Per Unit at Various Defect Levels

Annual Cost Units Cost Per Unit

Current Defect Level $480,000 100,000 $4.800

Defect Level with

Increased Line Speed $480,400 120,000 $4.003

Practical Capacity to

Handle Defects $480,500 125,000 $3.844

SIDEBAR 3: BASICS OF RCA

Resource consumption accounting (RCA) is based on costing

methods developed by German companies and the activity

costing philosophy of ABC. RCA takes a resource-based

view of an organization and looks closely at the quantity of

resources consumed and the underlying nature of the cost

of those resources. Some of the key characteristics of RCA

are the treatment of idle capacity, the use of costs other than

historical, and the ability to group and track cost information at

various levels. This comprehensive management accounting

system can lead to improved decision support by providing

more accurate product costs and a better understanding of the

interrelationships between processes and costs.

Table 1 Summary of Items Affected by the Need for High- or Low-gloss Finish on a Bumper

High Low Gloss Gloss

Rejection Rate high low

Number of Colors high low

Batch Size low high

Number of Painters high low

Table 2 Number of Products That Had Changes in Calculated Profit Margin from Standard Costing to ABC

Negative Margin Positive Margin

3 became more negative 5 became more positive

7 moved from negative to positive

1 became less negative 10 became less positive

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(P/TU) Adjusted Product (BDF) Profit per Complexity Demand Sq. Ft. per Bottleneck Profit per Throughput Yield Recovery Run Factor Factor Factor Unit of Demand Unit of Unit Profit Rate Rate (RF) = (CF) (DF) Product Sq. Ft. Finished per Sq. Ft. Product (YR) (RR) 1/(YR + RR) Speed = 18/speed = (RF x CF) (Sq. Ft.) = (DF/Sq. Ft.) Product /BDF

Compare Two Bumper Finishes

Low-Gloss Bumper 95% 5% 100% 15 1.20 1.20 10 .120 $10.00 $8.33

High-Gloss Bumper 92% 5% 103% 12 1.50 1.55 10 .155 $12.00 $7.76

Evaluate a Process Change

Current Process High-Gloss Bumper 92% 5% 103% 12 1.50 1.55 10 .155 $12.00 $7.76

Change Speed and YR 90% 6% 104% 13 1.38 1.44 10 .144 $12.00 $8.32

Table 3 Using Capacity Demand to Rank Profitability

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Receive raw (unpainted)

bumpers, luggage racks, etc.

Move to raw material storage

Receive customer release

Load, release, run MRP

Physical count of paints

Yes

Yes

Yes

No

No

No

Order paint, recieve into paint

storage area

Paint available?

Good part?

Schedule production

Run production

Pull paint racks

Hang paint racks

Pretreat/wash dry

Ecoat tank

Ecoat oven cure/bake

Adjust line speed for painters

Booth 1 primer

Booth 2 basecoat/enamel

top coat

Booth 3 clearcoat

Booth 4 clearcoat

Paint oven cure/bake

Ecoat Inspection

Finesse part (save)

Reject part

Unload finished parts

Unload paint racks

Transfer to finish goods storage, ship

Can defect be buffed out?

Figure 1 Diagram of the production process