This report discusses the utilization of activity based costing by our team to allocate costs and identifies flaws in the traditional system. We provide recommendations for Forest Hill Paper Company to consider implementing in the near future. After examining financial and production data, our accounting team has discovered that the company’s traditional cost allocation method is flawed and can be misleading. Specifically, products A and C have been allocated excessive costs while products B and D have been allocated insufficient costs, distorting the company’s true profits. Furthermore, product B may seem profitable but is actually losing $2307 per reel. It is clear that Forest Hill Paper Company has not effectively utilized its assets as suggested.
In terms of profitability, product D emerged as the most lucrative one, generating a profit of $5,299 per reel. On the other hand, product B proved to be the least profitable, resulting in a loss of $2,307 per reel. Furthermore, it was identified that slitting costs were being allocated to all products, even though they should only be allocated to products A and C. This is significant because slitting contributes approximately $2,300 in costs per reel, which should not be assigned to products B and D. Our team has examined various alternatives for Forest Hill to consider in order to increase its profit margin. For example, discontinuing the slitting service could be effective if it does not have a drastic impact on the current customer base. Moreover, the FHPC accountants should familiarize themselves with the ABC costing system to gain a better understanding of the company’s cost allocations and profits.
Analysis of Costing
Upon evaluation of the company’s costing procedures, it was found that the activity-based costing system yields significantly different profits compared to the traditional costing system. To calculate profit using the traditional method, we multiplied the materials cost by an overhead rate of 105%. Next, we deducted this value along with the materials cost from the sales price, resulting in the profits displayed in the table below.
Traditional Costing
Product
Average Reels per Batch
Price
Materials Cost per Reel
Contribution Margin
Overhead Cost per Reel
Profit (Loss)
A
50
$12,600
$4,800
$7,800
$5,040
$2,760
B
2
$13,500
$5,200
$8,300
$5,460
$2,840
C
35
$14,200
$5,600
$8,600
$5,880
$3,000
D
175
$19,500
$7,400
$12,100
$7,770
$4,330
The updated volume based overhead rate was calculated by multiplying the material cost per reel with each product’s number of reels and then dividing by the total cost of producing all four products. This resulted in a new volume based overhead rate of 91 percent.
To determine the cost of grade change per reel for each product, we divided the total grade change by the number of products (four) and further divided that number by the average reels per batch for each product.
Adjustments were also made to the cost of slitting. For products A and C, which undergo slitting, we divided the total cost of slitting by 85 (the average reels per batch for these products).
Finally, below is displayed the profit of each reel in the ABC costing system.
ABC Costing
Product
Average Reels per Batch
Price
Materials Cost per Reel
Contribution Margin
Overhead Cost per Reel
Profit (Loss)
A
50
$12,600
$4,800
$7,800
$6,897
$903
B
2
$13,500
$5,200
$8,300
$10,607
$(2,307)
C
35
$14,200
$5,600
$8,600
$7,726
$874
D
175
$19,500
$7,400
$12,100
$6,801
$5,299
The traditional costing system was deemed ineffective and inaccurate as it resulted in the overallocation of costs to A and C, while underallocating costs to product B and D. Consequently, this inaccurate allocation led to misconceptions about the profitability of product D, which appeared less profitable than it actually is, as well as A, B, and C which seemed more profitable than they truly are. The bar graph below highlights these findings.
Recommendations
Our recommendation for Forest Hill Paper Company is to take the following actions in order to increase profits and allocate costs effectively. Firstly, it would be strategically beneficial to continue production of products A, C, and D. However, discontinuing production of product B is advised since it is currently unprofitable and causing financial loss for the company. Specifically, product B has been resulting in a loss of $2,307 per reel for the company. If it is essential for the company to keep producing product B in order to maintain their customer base, we suggest altering the production schedule. For instance, during periods of lower demand, it is possible to produce less profitable products like B while still retaining customers and meeting their needs. Conversely, by discontinuing production of product B during times of higher demand, the company can focus on producing more profitable products such as A, C, and D. Another approach to increase profit related to product B is by producing consecutive batches in larger quantities.
The current cost of performing a grade change for product B is $5,875 per reel. If two consecutive batches of product B are done without a grade change, the cost of the grade change diminishes to $2,938 per reel, resulting in a profit of $625 per reel. Following the cessation or price increase of product B, we suggest implementing a year-long trial period to closely monitor the profitability of each product. In the event that Forest Hill continues to lose money, we propose eliminating the slitting process for products A and C. Dropping the slitting costs would generate an additional profit of approximately $2,300 per reel for products A and C. However, we acknowledge that ceasing slitting could reduce your competitive advantage and customer base. If slitting is determined to be essential, we recommend that customers be required to purchase enough of products A and C to distribute the slitting costs and increase overall profit. Additionally, we advise the company to begin transitioning from a volume-based costing system to an activity-based costing system.
To improve profitability, the company should allocate costs more efficiently to each product, as indicated in the aforementioned graphs. Specifically, slitting costs must be attributed only to the products utilizing the slitting machine. Additionally, if discontinuing product B is not viable, it is advised to carefully reassess the pricing strategy for each product. Increasing the price of product B could help offset the loss. After reviewing your financial records, these are the recommendations our team has formulated. While we acknowledge that there are other managerial aspects to consider, we strongly urge you to take our recommendations into serious consideration. We believe that implementing these suggestions can significantly enhance your company’s profits.
