|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.
The formula identifies two major sources of tax savings.
- 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.
- 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.
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:
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.