The text highlights a made-up denim processing plant that offers customized finishing services for denim pants manufactured by other companies. The case serves as a lesson in cost analysis for management decisions by examining the interdependencies between products in the production process and their associated costs. Specifically, the study focuses on the cost interdependency involved in retrofitting a finishing machine to transition from an existing stonewash process to a distressed finishing process requested by a new customer.
We discuss how the controller uses marginal costing and full cost activity-based costing (ABC) to advise management on the most profitable production decisions for the proposed contract. The Denim Finishing Company offers laundering and special finishing services for denim pants made by the original manufacturer. They specialize in transforming unwashed denim jeans and other denim products into various finishes like bleached, stonewashed, rinsed, and more. The factory has six machines, each with its own technical specifications for different products.
There is only one machine capable of achieving the “stonewash finish” using pumice stones. However, this machine, running at full capacity on three shifts, is unable to meet the current customer demand for this product. The Marketing Manager, Diane, suggested accepting a new customer contract from Guess Who Jeans. This contract involves a proprietary custom finish that will generate $7.00 in gross revenue per garment for 100 shipments, with each shipment containing 500 garments.
They need to be finished on the Unit 4 machine after converting it from stonewash to Guess Who “distressed” finishing. The revenue per garment for this finish is higher compared to the current revenue per garment for stonewashing. The majority of the company’s costs are overhead costs for each customer or finish. In order to maximize profit, it is important to know the cost of providing each finish because prices can be negotiated, some equipment has limited capacity due to high demand, and multiple finishes are available.
The Operations Manager, Tom, is worried that the expenses associated with labor and equipment downtime during the changeover process, as well as the low demand for the distressed finish in comparison to the stonewash finish, and the inability to use the distressed service for other customers, will reduce profitability. The CEO has assigned the task of conducting a cost analysis to the Controller, Kelsey, so that management can decide whether accepting the new contract will be financially advantageous. In her initial analysis, Kelsey utilized the company’s current costing system to evaluate the profitability of the new order.
She chose to disregard the costs associated with maintaining the facility and other fixed costs related to the current decision. The costs directly related to the number of garments processed are considered variable costs. Overhead costs are determined based on the cost hierarchy, which includes output unit-level cost, batch-level cost, product-sustaining costs, and facility-sustaining costs. Kelsey conducted an analysis of per unit product-sustaining costs for both stonewash only and using Unit #4 for both finishes. According to this analysis, the cost per unit for stonewash only batches was $0.56, while for batches with both finishes, it was $0.777. The changeover costs for machine conversion included labor and disposable supplies that would be eliminated if there were no changeover.
In relation to changeover costs, she argued that opportunity costs should also be considered, which should be calculated as the lost contribution margin of one batch of batch-level costs. She compared using Unit #4 for only stonewash or for both finishes, treating changeover costs as batch-level costs. However, she realized that her analysis might be flawed because the stonewash finish had always been profitable but appeared to be unprofitable in her analysis. She identified the problem with her analysis as the way she had classified the changeover costs as batch-level. She concluded that these costs should be categorized as product-sustaining since they are incurred when switching from one finishing process to another and are not incurred when running consecutive batches of the same finish on Unit #4. By treating changeover costs as product-sustaining costs, the stonewash-only option amounted to $0.195 per garment and the distressed option amounted to $0.02 per garment.
These costs appeared to be more reasonable. Both processes were profitable, with distressed garments showing higher profitability per unit in this analysis. However, this analysis still overlooks important interdependency costs. In her third and final analysis, Kelsey assessed the marginal revenues and costs of accepting the new order, taking into account the additional revenue generated for each additional finished unit.
The analysis conducted in this study involved deducting the opportunity cost linked to the decrease in sales of stonewash garments. This is because if the Guess Who order is accepted, it would result in a loss of 50,000 sales of stonewash garments due to the machine time needed for processing the new finish instead of stonewash. Additionally, there would be a loss of 20,000 sales of stonewash due to machine retool downtime. In the final analysis, the Marginal Cost Analysis shown in Exhibit 4 provides the closest consideration of the various cost interdependencies and factors that management requires to make an optimal profitability decision on whether to accept the new contract with Guess Who Jeans.
This analysis confirms the accuracy of the cost per garment and the profitability information provided by the company’s existing activity-based costing systems. Factors to think about in this situation include: the impact of changeover in the manufacturing process as a cost driver to be considered, non-financial factors that should be taken into account in the contract decision, possible alternatives to the two options presented (accepting or rejecting the contract), and how marginal costing analysis deals with cost interdependencies in product production.
In manufacturing, changeover is the process of converting a line or machine from running one product to another. When it comes to machine change-over, the idea being examined is to utilize an activity based costing hierarchy – unit level, batch level, product sustaining, and facility sustaining – for converting machine change over costs from running one product to another. Initially, it was believed that cost drivers would only include machine hours, number of batches, and number of garments. However, further analysis shows that lost opportunity sales of stonewash should also be considered as an additional cost driver.
The Controller’s viewpoint is that the lost opportunity costs should be classified as product sustaining costs instead of batch level costs. This is because they are associated with transitioning from one finishing process to another and do not occur when Unit #4 is producing consecutive batches of the same finish. Furthermore, there are non-financial factors to be considered such as evaluating the brand value, marketing potential, public relations impact, and future customer value that could be gained from a partnership with a forward-thinking and high-end company like Guess Who Jeans.
Could this contact potentially generate future business for Denim Finishing? Analyzing these issues is the type of data that a Certified Management Accountant may be required to perform. Utilizing customer focus groups, surveys, or competitor data could provide valuable information to present to management. Lastly, if we were the CEO, the questions we would ask the Controller are as follows:
Can you analyze if there are any potential cost reductions or accuracy improvements in administrative or downtime costs? Additionally, can you assess the lost opportunity of the stonewash business that is currently being outsourced and determine if it would be profitable to purchase another machine with Unit #4’s specifications, considering all direct labor and supply costs involved, if we retain all stonewash business and also use Unit #4 for other finishes?
Would the total volume of potential “new” or “retained” stonewash business justify investing in a new machine and additional labor? Does Exhibit 4’s Marginal Cost Analysis accurately represent our decision without comparing the total profit of all options, including facility overhead costs? Is the distressed finish always considered the marginal item for calculation? This case demonstrates that while activity-based costing can provide insight and accuracy, cost interdependencies between products, such as shared equipment, require a combination of activity-based costing and marginal costing analysis.
Marginal costing, also known as incremental costing, is a decision-making approach that uses marginal costs as the criterion for selecting products or processes. It involves analyzing the profitability of products, specifically the profit per garment on stonewash only, both finishes combined, and each finish individually when both were produced.
In addition to defining profitability variables, these exhibits also analyze the different costs of changeover when categorized as batch-level costs or product-sustaining costs. Nevertheless, the analysis of marginal costing takes it a step further by calculating the marginal revenues and costs involved in accepting a new order. This calculation includes the costs associated with downtime in machine changeover, which in this case results in the loss of 20,000 garments for re-tooling. Furthermore, it also factors in the lost sales of stonewash due to the utilization of the machine for the distressed finish, resulting in a loss of 50,000 stonewashed items.
Ultimately, based on the provided information, we conclude that the Controller’s final analysis utilizing marginal costing is the most comprehensive among all the analyses presented in the case. This analysis leads to the optimal decision for maximizing profits in production. In summary, this case highlights the importance of identifying cost drivers and utilizing marginal costing in manufacturing processes that involve shared equipment or labor. These factors play a crucial role in making management decisions that aim to maximize profit.
