This case details a fictional denim processing plant providing the service of custom finishing to denim pants for original manufacturers. The case is a lesson in how interdependencies among products in the production process and the costs associated with those interdependencies can be cost analyzed for management decisions. The retooling of a finishing machine change-over production from an existing stonewash process to accomplish a proposed distressed finishing process for a new customer, is the cost interdependency studied.
We explain how marginal costing and full cost activity-based costing (ABC) are used by the controller to present management product optimal (profit-maximizing) production decisions on the proposed contract.
The Denim Finishing Company provides laundering and special finishing of denim pants for the original manufacturer. Their specialty is converting unwashed denim jeans and other denim products a variety of finishes including bleached, stonewashed, rinsed, and other finishes. The factory utilizes six machines with differing technical specifications per product.
Only one machine can accomplish the “stonewash finish” using pumice stones in the machine, and running at capacity, is not able to fulfill the entire current customer demand for this product.
It currently is running at maximum capacity on three shifts. Denim Finishing Company’s new Marketing Manager in the case, Diane, proposed accepting a new customer contract from Guess Who Jeans for a proprietary custom finish that would yield gross revenue of $7. 00 per garment for 100 shipments of 500 garments per shipment.
They would require finishing on the Unit 4 machine, after a changeover process on the machine converting it from stonewash finishing to the Guess Who “distressed” finishing. This revenue per garment is much higher than current revenue per garment for the stonewashed finish. Most of the company’s costs are overhead with respect to any one customer or finish, and profit maximization requires understanding the cost of providing each finish, because prices are sometimes negotiable, demand exceeds capacity on some equipment, and a variety of finishes are offered.
The Operations Manager, Tom, is concerned that the cost of labor and downtime in equipment changeover, low volume of the distressed finish vs. the stonewash finish, and the fact that the distressed service could not be utilized for any other customer would lower profitability. The CEO has tasked the Controller, Kelsey, with performing a cost analysis in order for management to make a decision on whether accepting the new contract will be profitable. In her first analysis, Kelsey used the company’s existing costing system to assess the new order’s profitability.
She decided to ignore facility sustaining costs and other costs that don’t vary in respect to the current decision. Following is the data used in her analysis: Unit #4 Operational Data: Capacity| Batch time| Garments/batch| Revenue| Direct Costs Stonewash| Direct Costs Distressed| 7500 hours annually| 3 hours/batch| 100/batch| Stonewash=$2. 00 per garment| Supply=. 09| Supply=. 90| | | | Distressed=$7. 00 per garment| Shipping=. 10| Shipping=. 20| | | | | Total = $. 19| Total=$1. 10| Direct costs are variable with respect to the number of garments processed.
Overhead costs are based on the cost hierarchy of output unit-level cost, batch-level cost, product-sustaining costs, and facility-sustaining costs. In Exhibit 1, provided at end of text, Kelsey analyzed per unit product sustaining costs for both stonewash only and for using Unit #4 for both finishes. This analysis showed costs of $. 56 per unit of stonewash only batches and $. 777 per unit for batches of both finishes. The changeover costs to convert the machines included labor and disposable supplies that would be avoided if there were no changeover.
For changeover costs, she also reasoned opportunity costs should be measured as the lost contribution margin of one batch of batch-level costs. Treating change-over costs as batch level costs, Kelsey compared using Unit #4 for stonewash only versus using Unit #4 for both finishes. See Exhibit 2 at end of text. Kelsey then determined that this analysis could be flawed, because the stonewash finish had always proven to be profitable, but showed to be unprofitable in her nalysis. Kelsey identified the problem with her analysis as the way she had treated the change-over costs as batch level. She determined they should be classified at the product-sustaining level, since they relate to switching from one finishing process to the other, and are not incurred when Unit#4 is running consecutive batches of the same finish. When treating change-over costs as product sustaining costs, the stonewash only was $. 195 per garment and distressed was $. 02 per garment.
These cost seemed more reasonable. Both processes were profitable, but distressed seemed to be more profitable on a per garment basis in this analysis. However, this analysis still misses key interdependency costs. For her third and final analysis, Kelsey calculated the marginal revenues, or the additional revenue that would be generated for each additional finished unit, and costs of accepting the new order. This final analysis is presented in Exhibit 4.
This analysis included subtracting the opportunity cost associated with the reduction in sales of stonewash garments, since accepting the Guess Who order would result in 50,000 lost sales of stonewash garments due to machine time processing of the new finish instead of stonewash, and 20,000 lost sales of stonewash due to machine retool downtime. In this final analysis, the Marginal Cost Analysis in Exhibit 4 comes closest to including the many cost interdependencies and variables that management needs to make an optimal profitability decision on accepting the new contract with Guess Who Jeans.
This analysis validates the per garment cost and profitability information provided by the company’s existing activity based costing systems. Points to consider in this case include: how changeover in process in manufacturing is a cost driver to be considered, what non-financial issues should be considered in the contract decision, are there additional alternatives to the two presented (taking the contract or not accepting the contract), and how marginal costing analysis addresses cost interdependencies in product production.
In manufacturing, changeover is the process of converting a line or machine from running one product to another. In terms of machine change-over, the concept reviewed is to use 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. In this case, cost drivers were initially thought to only include machine hours, number of batches, and number of garments. However, further analysis supports using lost opportunity sales of stonewash as an additional cost driver.
We would agree with the Controller that these lost opportunity costs should be considered product sustaining costs rather than batch level, since they relate to switching from one finishing process to the other, and re not incurred when Unit #4 is running consecutive batches of the same finish. Secondly, non-financial issues that should be considered include: potential analysis of the brand valuation, marketing, public relations, or future potential customer value of a contract with a company like Guess Who Jeans, viewed as innovative and premium.
Could this contact result in future business for Denim Finishing? An analysis of these issues are the types of data a Certified Management Accountant could be asked to perform. Utilizing customer focus groups, surveys, or competitor data could yield informative data to present to management. Third, if we were in the position of the CEO, our questions for the Controller based on Exhibits 3 and 4 would include the following: 1. Is there any margin for potential reduction of administrative or down-time costs or are these highly accurate? . Can you do an analysis of the lost opportunity of the stonewash business currently being sent to competitors to determine if purchasing an additional machine with Unit #4’s specifications, plus all other direct labor and supply costs incurred, would be profitable if we retained all stonewash business currently being turned away, plus the lost opportunity business if we use Unit #4 for both finishes?
Would the combined volume of potential “new” or “retained” stonewash business justify capital investment in a new machine plus dditional labor investment? 3. Does Exhibit 4’s Marginal Cost Analysis accurately reflect our decision without a comparative total profit analysis of all options, including facility overhead costs? 4. Is the new product, the distressed finish, always going to be the marginal item to calculate? This case shows that while use of activity based costing can be informative and sometimes accurate, cost interdependencies among products, as in the case of shared equipment requires a combination of activity based costing and marginal costing analysis.
Marginal costing is a decision making approach in which marginal costs are used as the basis for choosing which product to make or which process to use. It is also called incremental costing. In this case, the product profitability analysis in Exhibits 2 and 3 defined for management the profit per garment on stonewash only, both finishes together, and each finish individually when both were run.
These exhibits also define profitability variables when treating changeover costs as batch-level costs versus product-sustaining costs. Exhibit 4’s marginal costing analysis goes a critical step further by calculating the marginal revenues and costs of accepting the new order including the costs of downtime in machine changeover (20,000 lost garments for re-tooling) and lost sales of stonewash due to utilizing the machine for the distressed finish (50,000 lost stonewash).
Finally, with the information given, we agree that the Controller’s final marginal costing analysis is the most comprehensive of all the analyses shown in the case to lead to the optimal profit maximizing production decision. In conclusion, this case shows that the variables in manufacturing processes per products using shared equipment or labor, require in-depth cost driver identification and marginal costing to contribute to profit maximizing management decisions.
Cite this Activity Based Costing Draft
Activity Based Costing Draft. (2016, Oct 02). Retrieved from https://graduateway.com/activity-based-costing-draft/