Activity-Based Costing, Distorted Product Costs

Sharp Paper Inc. has three paper mills, one of which is located in Memphis, Tennessee. The Memphis mill produces 300 different types of coated and uncoated specialty printing papers. Management was convinced that the value of the large variety of products more than offset the extra costs of the increased complexity.

During 20X1, the Memphis mill produced 120,000 tons of coated paper and 80,000 tons of uncoated paper. Of the 200,000 tons produced, 180,000 were sold. Sixty products account for 80% of the tons sold. Thus, 240 products are classified as low-volume products.

Lightweight lime hopsack in cartons (LLHC) is one of the low-volume products. LLHC is produced in rolls, converted into sheets of paper, and then sold in cartons. In 20X1, the cost to produce and sell one ton of LLHC was as follows:

Direct materials:
Furnish (3 different pulps)	2,225 pounds	$450
Additives (11 different items)	200 pounds	500
Tub size	75 pounds	10
Recycled scrap paper	(296 pounds)	(20)
Total direct materials		$940
Direct labor		$450
Overhead:
Paper machine ($100 per ton 2,500 pounds)		$125
Finishing machine ($120 per ton 2,500 pounds)		150
Total overhead		$275
Shipping and warehousing		$30
Total manufacturing and selling cost		$1,695

Overhead is applied by using a two-stage process. First, overhead is allocated to the paper and finishing machines by using the direct method of allocation with carefully selected cost drivers. Second, the overhead assigned to each machine is divided by the budgeted tons of output. These rates are then multiplied by the number of pounds required to produce one good ton.

In 20X1, LLHC sold for $2,400 per ton, making it one of the most profitable products. A similar examination of some of the other low-volume products revealed that they also had very respectable profit margins. Unfortunately, the performance of the high-volume products was less impressive, with many showing losses or very low profit margins. This situation led Ryan Chesser to call a meeting with his marketing vice president, Jennifer Woodruff, and his controller, Kaylin Penn.

Ryan: The above-average profitability of our low-volume specialty products and the poor profit performance of our high-volume products make me believe that we should switch our marketing emphasis to the low-volume line. Perhaps we should drop some of our high-volume products, particularly those showing a loss.

Jennifer: I'm not convinced that solution is the right one. I know our high-volume products are of high quality, and I'm convinced that we are as efficient in our production as other firms. I think that somehow our costs are not being assigned correctly. For example, the shipping and warehousing costs are assigned by dividing these costs by the total tons of paper sold. Yet

Kaylin: Jennifer, I hate to disagree, but the $30-per-ton charge for shipping and warehousing seems reasonable. I know that our method to assign these costs is identical to a number of other paper companies.

Jennifer: Well, that may be true, but do these other companies have the variety of products that we have? Our low-volume products require special handling and processing, but when we assign shipping and warehousing costs, we average these special costs across our entire product line. Every ton produced in our mill passes through our mill shipping department and is either sent directly to the customer or to our distribution center and then eventually to customers. My records indicate quite clearly that virtually all of the high-volume products are sent directly to customers, whereas most of the low-volume products are sent to the distribution center. Now, all of the products passing through the mill shipping department should receive a share of the $2,000,000 annual shipping costs. I'm not convinced, however, that all products should receive a share of the receiving and shipping costs of the distribution center as currently practiced.

Ryan: Kaylin, is this true? Does our system allocate our shipping and warehousing costs in this way?

Kaylin: Yes, I'm afraid it does. Jennifer may have a point. Perhaps we need to reevaluate our method to assign these costs to the product lines.

Ryan: Jennifer, do you have any suggestions concerning how the shipping and warehousing costs should be assigned?

Jennifer: It seems reasonable to make a distinction between products that spend time in the distribution center and those that do not. We should also distinguish between the receiving and shipping activities at the distribution center. All incoming shipments are packed on pallets and weigh one ton each. There are 14 cartons of paper per pallet. In 20X1, the receiving department processed 56,000 tons of paper. Receiving employs 15 people at an annual cost of $600,000. Other receiving costs total about $500,000. I would recommend that these costs be assigned by using tons processed.

Shipping, however, is different. There are two activities associated with shipping: picking the order from inventory and loading the paper. We employ 30 people for picking and 10 for loading, at an annual cost of $1,200,000. Other shipping costs total $1,100,000. Picking and loading are more concerned with the number of shipping items than with tonnage. That is, a shipping item may consist of two or three cartons instead of pallets. Accordingly, the shipping costs of the distribution center should be assigned by using the number of items shipped. In 20X1, for example, we handled 190,000 shipping items.

Ryan: These suggestions have merit. Kaylin, I would like to see what effect Jennifer's suggestions have on the per-unit assignment of shipping and warehousing for LLHC. If the effect is significant, then we will expand the analysis to include all products.

Kaylin: I'm willing to compute the effect, but I'd like to suggest one additional feature. Currently, we have a policy to carry about 25 tons of LLHC in inventory. Our current costing system totally ignores the cost of carrying this inventory. Since it costs us $1,665 to produce each ton of this product, we are tying up a lot of money in inventorymoney that could be invested in other productive opportunities. In fact, the return lost is about 16% per year. This cost should also be assigned to the units sold.

Ryan: Kaylin, this also sounds good to me. Go ahead and include the carrying cost in your computation.

To help in the analysis, Kaylin gathered the following data for LLHC for 20X1:

Tons sold	10
Average cartons per shipment	2
Average shipments per ton	7

Required:

1. Identify the flaws associated with the current method of assigning shipping and warehousing costs to Sharps products.

Shipping and warehousing costs are currently assigned using tons of paper produced, a unit based measure. Many of these costs, however, are not driven by quantity produced. Many products have special handling and shipping requirements involving extra costs. These costs should not be assigned to those products that are shipped directly to customers.

2. Compute the shipping and warehousing cost per ton of LLHC sold by using the new method suggested by Jennifer and Kaylin. Round rates and the cost per ton to two decimal places. Shipping and warehousing cost $ per ton sold.

3. Using the new costs computed in Requirement 2, compute the profit (or loss) per ton of LLHC. If necessary, round intermediate calculations and final answer to two decimal places. Use the minus sign to indicate loss. Revised profit (or loss) $ per ton of LLHC.

Compare this with the profit per ton computed by using the old method. Do you think that this same effect would be realized for other low-volume products?

The revised profit, reflecting a more accurate assignment of shipping and warehousing costs, presents a much different picture of LLHC. The product is, in reality, losing money for the company. Its earlier apparent profitability was attributable to a subsidy being received from the high-volume products (by spreading the special shipping and handling costs over all products, using tons produced as the cost driver). The same effect is also true for the other low-volume products. Essentially, the system is understating the handling costs for low-volume products and overstating the cost for high-volume products.

4. Comment on Ryans proposal to drop some high-volume products and place more emphasis on low-volume products. Discuss the role of the accounting system in supporting this type of decision making.

The decision to drop some high-volume products and emphasize low-volume products could clearly be erroneous . As LLHC has demonstrated, its apparent profitability is attributable to distorted cost assignments. A significant change in the image of LLHC was achieved by simply improving the accuracy of shipping and handling costs . Further improvements in accuracy in the overhead assignments may cause the view of LLHC to deteriorate even more. Conversely, the profitability of high-volume products may improve significantly with increased costing accuracy. This example underscores the importance of having accurate and reliable accounting information. The accounting system must bear the responsibility of providing reliable information.

5. After receiving the analysis of LLHC, Ryan decided to expand the analysis to all products. He also had Kaylin reevaluate the way in which mill overhead was assigned to products. After the restructuring was completed, Ryan took the following actions: (a) the prices of most low-volume products were increased, (b) the prices of several high-volume products were decreased, and (c) some low-volume products were dropped. Explain why his strategy changed so dramatically.

Ryans strategy changed because his information concerning the individual products changed. Apparently, the accounting system was undercosting the low-volume products and overcosting the high-volume products. Once better information was available, Ryan was able to respond better to competitive conditions.