1. Compute the allocation rate that was used for manufacturing overhead in Exhibits 2 and 3. Using these rates, show the computations that were used for allocating manufacturing overhead in Exhibits 2 and 3.

2. Exhibit 4 shows a negative $15,000 overhead volume variance. Explain why it exists and why it is negative.

3. Exhibit 4 also shows a positive $2,800 overhead budget variance. What are the potential causes for it?

4. In Exhibit 4, the operating income is larger under absorption costing than under variable costing. Why? Please be very explicit in explaining the reason(s) for the difference.

5. Use the information in Exhibit 1 to identify cost drivers and compute manufacturing overhead rates for machine maintenance, machine set up labor, and material handling. Use these overhead rates to calculate the cost of goods manufactured for a pair of machine-made shoes and a pair of handmade shoes, and compute the margin percentages for each.

6. Ms. Nadalini has asked you if SISP A should get out of the machine-made shoe business. What do you recommend and why?

THE CRIMSON PRESS CURRICULUM CENTER THE CRIMSON GROUP, INC. Scarpe Italiane, S.p.A. Is this diversification move good or not? First you tell me that machine-made shoes are money makers, then you tell me we're losing a bundle on each pair. Which is it? The speaker was Francesca Nadalini, CEO of Scarpe Italiane, S.p.A. (SISPA). SISPA had been manufacturing shoes in Italy for several generations. Three years ago, Ms. Nadalini had completed her B.S. in Business Administration, and had been asked by her father, the company's president, to initiate SISPA's North American operations. She commented: We've grown a lot and done well in the past three years. Most of our shoes are handmade, using very little in the way of machines, and we charge a premium price for them. Recently, however, we decided to diversify so we could compete with the more automated manufacturers. We purchased some specialized equipment that we installed in our plant and that we use only for the machine-made shoes. We use very little labor to make these kinds of shoes. The problem now is that we don't seem to know how much it costs us to make either kind of shoe. It was easy when we produced only handmade shoes, but matters are now much more complicated. The problem seems to be with overhead allocation. SISPA's overhead costs and some related information, are shown in Exhibit 1. Giovanni Hoff- man, SISPA's chief accountant, commented on the nature of the problem: When we produced only handmade shoes, we allocated all our manufacturing overhead [MOH] to them and there was no problem. Our MOH is relatively high, since receiving and handling the materials from each leather shipment takes a lot of time. Also, as part of receiving and handling, we cut and prepare much of the leather before it enters manufacturing, all of which we consider to be manufacturing overhead. The shift to machine-made shoes has meant more than just some increased depreciation, which we consider to be a direct cost, since we use completely different machines for machinemade shoes than for handmade ones. In addition, however, all the machines need to be repaired and maintained, which seems to be a function of the number of hours that each machine is used. Our repair and maintenance crew works on all of the machines, so we consider them to be part of manufacturing overhead. Then there's setup time for the machines, which is related to the number of batches we run. The handmade shoes are stitched and formed individually, but then finished up on a machine in batches. And, of course, all of the machine-made shoes are run in batches. A batch is a group of shoes of the same size, and we have to set up the machines to accommodate the particular size. Our setup crew works on all of the machines, so we consider them to be part of manufacturing overhead also. Ms. Nadalini's concern about costs arose because Mr. Hoffman had presented her with some conflicting information. Initially, Mr. Hoffman had allocated overhead to shoes on the basis of direct labor dollars, as shown in Exhibit 2. Then, deciding that machine hours drove the use of much of the overhead, he had used machine hours to allocate the overhead, as shown in Exhibit 3. Ms. Nadalini commented: With the first approach, I was pleased. The machine-made shoes were showing a bigger margin percent than the handmade ones, which didn't completely make sense to me, since the market for machine-made shoes is much more competitive than the market for handmade shoes, but I thought that perhaps we were doing something better than our competitors. Then along comes the report using machine hours as the basis for allocating overhead. Wow! The margin percent on our handmade shoes is terrific, but we're losing a bundle on the machine-made ones. On top of all of this, Giovanni has told me that, because we have so much fixed manufacturing overhead, we should be using variable costing, and he's put together a set of financial statements using variable costing that shows we're losing money [Exhibit 4]. This just doesn't make sense, although I suppose if the margins on the machine-made shoes are as bad as they now seem to be, maybe it's true. If so, though, why doesn't the loss show up on the absorption costing statement? At this point, I'm not sure what to do. We've just begun producing machine-made shoes, and are making only a few hundred pairs right now, but this problem could get much bigger if we increase production. My sense is that we should get out of the machine-made shoe business, and stick with handmade shoes. We were doing pretty well at that before we began to diversify. It seems as though we've made a big mistake. Or maybe it's all in the accounting ________________________________________________________________________ This case was prepared by Professor David W. Young. It is intended as a basis for class discussion and not to illustrate either effective or ineffective handling of an administrative situation.Copyright 2014 by The Crimson Group, Inc. To order copies or request permission to reproduce this document, contact Harvard Business Publications (http://hbsp.harvard.edu/). Under provisions of United States and international copyright laws, no part of this document may be reproduced, stored, or transmitted in any form or by any means without written permission from The Crimson Group (www.thecrimsongroup.org) Assignment: 1. Compute the allocation rate that was used for manufacturing overhead in Exhibits 2 and 3. Using these rates, show the computations that were used for allocating manufacturing overhead in Exhibits 2 and 3. 2. Exhibit 4 shows a negative $15,000 overhead volume variance. Explain why it exists and why it is negative. 3. Exhibit 4 also shows a positive $2,800 overhead budget variance. What are the potential causes for it? 4. In Exhibit 4, the operating income is larger under absorption costing than under variable costing. Why? Please be very explicit in explaining the reason(s) for the difference. 5. Use the information in Exhibit 1 to identify cost drivers and compute manufacturing overhead rates for machine maintenance, machine set up labor, and material handling. Use these overhead rates to calculate the cost of goods manufactured for a pair of machine-made shoes and a pair of handmade shoes, and compute the margin percentages for each. 6. Ms. Nadalini has asked you if SISP A should get out of the machine-made shoe business. What do you recommend and why? SCARPE ITALIANE, INC. Exhibit 1. Manufacturing Overhead Statistics and Costs Most Recent Accounting Period Machine-Made handmade Total Manufacturing Statistics Number of pairs produced 400 1,000 1,400 Number of machine hours 800 200 1,000 Number of batches 5 35 40 Raw material shipments received 2 18 20 Manufacturing Overhead Costs Machine maintenance $50,000 Machine set up labor 115,000 Material handling 235,000 Total $400,000 Exhibit 2. Overhead Allocated with Direct Labor Dollars Machine-Made handmade Total Direct labor $5,000 $35,000 $40,000 Direct materials 7,000 18,000 25,000 Machine depreciation (direct) 25,000 5,000 30,000 Manufacturing overhead 50,000 350,000 400,000 Cost of goods manufactured $87,000 $408,000 $495,000 Full cost per pair $217.50 $408.00 Price per pair $300.00 $500.00 27.5% 18.4% Margin percent per pair Exhibit 3. Overhead Allocated with Machine Hours Machine-Made handmade Total Direct labor $5,000 $35,000 $40,000 Direct materials 7,000 18,000 25,000 Machine depreciation (direct) 25,000 5,000 30,000 Manufacturing overhead 320,000 80,000 400,000 Cost of goods manufactured $357,000 $138,000 $495,000 Full cost per pair $892.50 $138.00 Price per pair $300.00 $500.00 -197.5% 72.4% Margin percent per pair Exhibit 4. Comparative Income Statements Absorption Costing Variable Costing Sales $530,000 $530,000 Cost of goods sold (COGS) 450,000 210,000 Gross margin $80,000 $320,000 Overhead volume variance (15,000) 0 Overhead budget variance 2,800 2,800 Adjusted gross margin $67,800 $322,800 Less: Fixed manufacturing overhead 0 270,000 Less: Selling, general, and administrative 58,000 58,000 Operating income $9,800 $(5,200)