Key activity-based costing concepts
Wellington Boot and Shoe Company makes hand-sewn boots and shoes. Wellington uses a companywide overhead rate based on direct labor hours to allocate indirect manufacturing costs to its products. Making a pair of boots normally requires 2.4 hours of direct labor, and making a pair of shoes requires 1.8 hours. The company’s shoe division, facing increased competition from international companies that have access to cheap labor, has responded by automating its shoe production. The reengineering process was expensive, requiring the purchase of manufacturing equipment and the restructuring of the plant layout. In addition, utility and maintenance costs increased significantly for operating the new equipment. Even so, labor costs decreased significantly. Now making a pair of shoes requires only 18 minutes of direct labor. As predicted, the labor savings more than offset the increase in overhead cost, thereby reducing the total cost to make a pair of shoes. The company experienced an unexpected side effect, however; according to the company’s accounting records, the cost to make a pair of boots increased although the manufacturing process in the boot division was not affected by the reengineering of the shoe division. In other words, the cost of boots increased although Wellington did not change anything about the way it makes them.
a. Explain why the accounting records reflected an increase in the cost to make a pair of boots.
b. Explain how the companywide overhead rate could result in the under pricing of shoes.
c. Explain how activity-based costing could improve the accuracy of overhead cost allocations.