The Tax Benefits of ABC

Companies with the right production and cost characteristics can achieve considerable savings.
BY STEVEN C. DILLEY, FRED H. JACOBS AND RONALD M. MARSHALL

EXECUTIVE SUMMARY
  • THE BENEFITS OF ACTIVITY-BASED costing are well documented. Less well known are the substantial income tax savings that some companies can achieve if ABC is used to determine taxable income.
  • TAX SAVINGS COME FROM TWO MAJOR sources. There will be savings if some of a company's products use large amounts of the single plantwide cost driver but very few of the ABC drivers. There also will be savings in the year a company switches to ABC if average overcosted product inventory levels, as a percentage of production, exceed average undercosted product inventory levels.
  • ADDITIONAL FACTORS CAN AFFECT THE amount of tax savings available by using ABC. These include annual overhead cost changes, production level changes, the uniform capitalization rules of IRC section 263A, inventory flow assumptions and the use of alternate costing systems.
  • SWITCHING FROM A PLANTWIDE overhead allocation system to an ABC system for tax purposes constitutes a change in accounting method and requires Internal Revenue Service approval. Taxpayers must file Form 3115, Application for Change in Method of Accounting .
  • MANY COMPANIES ARE RELUCTANT TO switch to ABC because they are unsure of the benefits. However, if a company has particular production and cost characteristics, the available tax benefits are certain, predictable and potentially significant.
Steven C. Dilley, CPA, PhD, JD, is professor of accounting at Michigan State University, East Lansing.
Fred H. Jacobs, CPA, PhD, is associate professor of accounting at Michigan State University.
Ronald M. Marshall, CPA, PhD, is associate professor of accounting at Michigan State University.


T he overall benefits of activity-based costing (ABC) have been well documented over the past decade. By providing cost driver and product cost information that is more precise than plantwide allocation systems, ABC systems usually result in better strategic decisions and process control. Yet there is another potential benefit of ABC. In a wide variety of circumstances, a company can realize significant tax savings if it uses ABC to determine taxable income. Although the savings will be greatest in the year of the switch from a plantwide system, there should be benefits in the years following the change as well. This article demonstrates the potentially significant impact ABC can have on the tax liability of some companies.



HOW IT WORKS
Consider, for example, a simplified company, Jupiter, Inc., that switches from a traditional plantwide overhead allocation system to an ABC system. Jupiter produces only two products, Hi-V and Lo-V. Hi-V is a high-volume product that represents the company's major source of revenue and profit. It is produced once a month, inventoried and shipped to customers twice a month. Lo-V is a specialty product that is made to order for several smaller customers. It is produced each time an order is placed-usually once a week-and immediately shipped to the customer.

The plantwide system uses direct labor hours to allocate costs. The ABC system has five overhead cost pools (engineering, receiving, setup, packing and all other) and corresponding cost drivers (engineering change orders, receiving orders, setups, shipments and machine hours). Detailed cost, activity, production and sales data for Jupiter are shown in exhibit 1.


Product cost computations for both systems are shown in exhibit 2, at right. Jupiter is a typical manufacturing company, with approximately 60% of its product costs in direct materials, 10% in direct labor and 30% in overhead. The traditional system overcosts (assigns too much of the costs to) Hi-V by $18.51 per unit, or 27% of its ABC cost, and undercosts Lo-V by $37.01, or 54%.

A company of this type often is used to illustrate the weaknesses of a plantwide allocation system and the strength of ABC. When products place significantly diverse demands on manufacturing resources, no single cost driver can accurately reflect those demands and yield accurate product costs. The high-volume product that uses a disproportionately small share of manufacturing support services will be overcosted, and the low-volume product that uses a disproportionately large share of support services will be undercosted.

Income statements for year 1, the year of Jupiter's switch to ABC, and for year 2, the year after, are shown in exhibit 3 and exhibit 4 . Typical gross margin and profit margin percentages of approximately 30% and 10%, respectively, are assumed, along with a 34% tax rate. In year 1, the change to ABC increases the cost of goods sold and thus decreases taxable income by $22,207. As a result, taxes are reduced by $7,550, or 11%. In year 2, the reduction in taxable income is $3,701, with corresponding tax savings of $1,258, or approximately 2%.



BASIC SOURCES OF TAX SAVINGS
The following general formula can be used to explain and predict the tax savings a company can expect by switching from a plantwide to an ABC system.

Tax savings = (allocation error   x   inventory difference)   x  tax rate The allocation error is the sum of the allocation errors for all of the company's overcosted products. The inventory difference refers to the difference between the average inventories of the overcosted products and undercosted products as a percentage of production. For example, using the amount that Hi-V is overcosted (from exhibit 2 ) and the inventory differences between Hi-V and Lo-V (from exhibit 1 ), the tax savings for Jupiter can be calculated: Tax savings = ($222,065 3 .10) 3 .34 = $7,550

The formula identifies two major sources of tax savings.

  1. There will be savings if some of a company's products use large amounts of the single plantwide driver but very few of the ABC drivers. In Jupiter's case, Hi-V uses 86% of the direct labor hours but an average of only 25% of the five nonvolume drivers. Lo-V uses only 14% of the direct labor hours but 75% of the ABC drivers.
  2. There will be savings in the year of the switch if average overcosted product inventory levels, as a percentage of production, exceed average undercosted product inventory levels. After that, the average change in overcosted product inventory levels must be larger. For Jupiter, in year 1 the inventory of the overcosted Hi-V is 10% of its production, compared with 0% for the undercosted Lo-V. In year 2, the inventory of Hi-V increases, while there is still no Lo-V inventory.



OTHER CONSIDERATIONS
Both of the above factors must be present for there to be any tax savings. Some additional factors could affect the amount of tax savings:

      Annual overhead cost changes. If annual overhead costs increase, tax savings under ABC also increase. For Jupiter, if overhead costs in year 2 increase by 5%, tax savings increase from 2% to 3%. In fact, after a company has switched to ABC, overhead cost increases can produce tax savings even if inventory percentages don't change.

      Production level changes. If production levels increase, tax savings under ABC usually increase as well. For Jupiter, if the year 2 Hi-V inventory increase occurs because of increased production, and if 75% of overhead costs are variable, tax savings in year 2 increase from 2% to 3%. Thus, in general, a growing company with increasing production, sales and inventories will benefit even more than Jupiter.

      Uniform capitalization rules. Internal Revenue Code section 263A requires capitalization of more premanufacturing and postmanufacturing costs. This usually will lead to greater allocation errors and increased tax savings.

      Inventory flow assumptions. For Jupiter, the inventory flow assumption was first-in, first-out. In a last-in, first-out system, the impact of a switch to ABC depends on the extent to which older inventory layers become part of cost of goods sold.

      Alternate costing systems. These systems initially trace overhead costs to specific manufacturing support and production departments and then use departmental rates to allocate these costs to individual products. Such departmental systems are more accurate than plantwide systems but less accurate than ABC systems. As a result, allocation errors and corresponding tax savings will be smaller for companies that switch from a plantwide system to a departmental system or from a departmental system to an ABC system.

Exhibit 5 summarizes the major factors that contribute to income differences and tax savings.



MAKING THE SWITCH
A switch from a plantwide overhead allocation system to an ABC system for tax purposes constitutes a change in accounting method and requires Internal Revenue Service approval. Companies seek this approval by filing Form 3115, Application for Change in Method of Accounting . Taxpayers are required to disclose the adjustment under IRC section 481, which shows the difference in taxable income with and without the accounting method change. If the cutoff method is selected, or if the adjustment is $25,000 or less, the adjustment can be taken in the year of the change. Otherwise, it must be spread over a number of years, based on an agreement between the taxpayer and the IRS. For a Lifo taxpayer, completing form 3115 and computing the adjustment is substantially more complex because of the need to restate the various Lifo layers.



THE CHOICE IS ABC
Surveys have suggested that one of the major reasons for the reluctance of companies to switch to ABC systems is the uncertainty of the resulting benefits. Because strategic decisions depend, in part, on noncontrollable, external factors, benefits attributable to more precise product costs often are difficult to quantify or even realize. These difficulties, however, do not apply to tax benefits. If a company's production and cost characteristics are consistent with those described here, the benefits are certain, predictable and potentially significant.

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