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 2011, 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 percent 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 2011 the cost to produce and sell one ton of LLHC was as follows:

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 2011, 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 2011, 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 2011, 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 inventory—money that could be invested in other productive opportunities. In fact, the return lost is about 16 percent 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 2011:

Required:

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

2. Compute the shipping and warehousing cost per ton of LLHC sold by using the new method suggested by Jennifer and Kaylin.

3. Using the new costs computed in Requirement 2, compute the profit 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? Explain.

4. Comment on Ryan’s 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.

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.
 
 

Direct materials: Furnish (3 different pulps) Additives (11 different items) Tub size Recycled scrap paper Total direct materials Direct labor Overhead: Paper machine ($100 per ton x 2,500 pounds) Finishing machine ($120 per ton x 2,500 pounds) Total overhead Shipping and warehousing Total manufacturing and selling cost 2,225 pounds 200 pounds 75 pounds (296 pounds) $ 450 500 10 (20) $940 $450 $ 125 150 $ 275 $ 30 $1,695 Tons sold Average cartons per shipment Average shipments per ton 10 2 7