At the present time, demand for stonewash by Blue Jeanss customers exceeds the companys capacity to supply this finish, so the company runs Unit #4 on all three shifts, and some customers source this finish from other laundries as well. Currently, Blue Jeans provides about a dozen different finishes to four major customers, and also provides some of these same finishes to other customers that use the company occasionally. Four years ago, management adopted an activity-based costing system. Most of the companys costs are overhead with respect to any one customer or type of finish, and profit maximization requires a sound understanding of 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 CONTROLLER.S ANALYSIS Grahams First Pass In the afternoon on the same day as the meeting, Graham used Blue Jeanss existing costing system to assess the profitability of accepting the new order for the proprietary distressed finish. For this analysis, Graham decided to ignore facility-sustaining costs and other costs that clearly dont vary with respect to the decision at hand. Following is the relevant information. Operational Data for Unit #4 Capacity: the machine can run approximately 7,500 hours annually, using three shifts daily (a 9-hour day shift, a 9-hour second shift, and a 6-hour night shift), six days per week (the facility closes one day weekly, on a rotating schedule, and any required machine maintenance is scheduled for that day). This assumes the machine runs only one finish, so there is no downtime retooling the machine for a different finishing operation. Batch time: three hours per batch, for both the stonewash and the proprietary distressed finishes. This estimate includes time to load and unload Unit #4, but ignores materials-handling time that does not tie up the machine. Garments per batch: 100 garments per batch for both stonewash and the proprietary distressed finish. If Blue Jeans accepts the order from Guess Who, anticipated demand would be 100 shipments of the proprietary distressed finish, with 500 garments per shipment. This implies that five consecutive batches of the proprietary finish would be processed on each of 100 days during the year. Betty told Graham that she anticipates these shipments would be received on a schedule such that no two shipments could be run back-to-back. Demand for stonewash is effectively unlimited, so Blue Jeans could .fill in. on Unit #4 with stonewash whenever the machine was not used for the proprietary process. Revenue data: The revenue for stonewash is $2.00 per garment, and for the proprietary distressed finish is $7.00 per garment. Direct costs: Direct costs are effectively variable with respect to the number of garments processed. Disposable supplies for stonewash consist of pumice stone, and for the proprietary distressed finish, consist of a detergent and also an abrasive natural rock product. Shipping refers to the cost to ship the garments back to the manufacturer. Stated on a per-garment basis, these direct costs are as follows: Direct Costs: Stonewash Finish GuessWho Distressed Finish Disposable Supplies $0.09 $0.90 Shipping $0.10 $0.20 Total $0.19 $1.10 Overhead costs: The Blue Jeans Company classifies overhead costs into four cost pools, based on the cost hierarchy of output unit-level costs, batch-level costs, product-sustaining costs, and facility-sustaining costs. Batch-Level and Output Unit-Level Costs Batch-level costs consist of utility expense and batch set-up costs for both washing and drying operations. Output unit-level overhead costs consist of wages for materials-handlers. These materials- handlers receive shipments of garments and batch them for processing. After the garments have been processed through the washing and drying operations, the materials-handlers prepare finished garments for shipment back to the customer. All batch-level and output unit-level costs have the same resource requirements, stated on a per garment basis, for the proprietary distressed finish as for the stonewash finish. This is partly due to the fact that batch sizes and machine cycle times are the same for both processes. Batch-level and output unit-level cost information is as follows: Batch-level costs: Cost Driver Overhead Rate OverHead Cost/Garment Utility expense Machine hours $7.50 per hour $0.45 Set-up costs Number of batches $25 per batch $0.25 Output unit-level costs Materials handling Number of garments $0.10 per garment $0.10 The per-unit utility expense is based on six machine hours per batch: three for washing and three for drying. Hence, $7.50 per hour 6 machine hours 100 garments per batch = $0.45 per garment. Product-Sustaining Costs Product-sustaining costs can be ignored for all processes other than stonewash and the proprietary finish (the two processes that utilize Unit #4). Product-sustaining costs for these two processes are fixed costs that are incurred if that particular finish is run, and are avoidable if the finish is not run. If the finish is run, then these costs are fixed, and do not vary with respect to the number of batches or the number of garments per batch. Hence, the per-garment product-sustaining cost is an allocation of fixed costs, and varies for stonewash depending on the number of units run. Product-sustaining costs for stonewash are $140,000 annually. These costs consist of rental payments on equipment to store and handle the pumice stone, and payments to a consultant who has considerable expertise with the stonewash finish. The consultant supervises the quality assurance process for stonewash, as well as sourcing of the pumice stone. The product-sustaining per-unit cost depends on the volume of stonewash product, as shown in Exhibit 1. Product-sustaining costs for the proprietary distressed finish are $37,500 annually, or $0.75 per garment. These costs consist principally of monthly lease payments on equipment required to treat the wastewater discharged from Unit #4 when the proprietary distressed finish is run on that machine, before the wastewater can be released into the local sewer system. There are also annual fixed costs for this finish that relate to regulatory permits for the wastewater discharge. Facility-Sustaining Costs These costs can be ignored, because they are expected to remain constant regardless of how Unit #4 is used. Hence, they are not incremental costs with respect to the decision at hand. Machine Change-Over Costs There are additional costs that Graham was unsure how to classify. These are costs associated with converting Unit #4 between stonewash and the proprietary distressed finish, and they are in addition to the usual batch-level set-up costs. The change-over costs include shop-floor labor to clean and retool the machine. Clark told Graham that he would need two hourly workers for four hours each to perform these activities, although the machine would only be down for three of the four hours. When Graham shared this information with Betty, Betty thought it sounded very reasonable. Graham estimated the wage rate for these two employees at $25 per hour. The change-over costs also include disposable supplies (such as cleaning supplies) of $50 per change-over. Hence, the total out-of-pocket change-over costs would be $250 ($25 per hour 4 hours 2 employees; plus $50 in supplies). These costs would be avoided if Unit #4 were used for either finish exclusively. In addition, there was an opportunity cost that Graham knew was relevant, but that the accounting system would not normally incorporate. Unit #4 would require 3 hours of downtime whenever the machine was retooled to switch from one finish to the other. Since three hours represented one batch of product, running both products would reduce the total number of batches run on Unit #4 from 2,500 to 2,300 (100 conversions from stonewash to the proprietary finish, and 100 conversions back to stonewash). Graham reasoned that the opportunity cost should be measured as the lost contribution margin on sales of stonewashed product, and she calculated the contribution margin of one batch of stonewash as $200 in revenue less $19 in direct costs, $10 in materials handling costs, and $70 in batch-level costs, for a lost contribution margin of $101 per change-over. These calculations result in an estimate of out-of-pocket change-over costs of $250 per changeover and an opportunity cost of $101 per change-over. Therefore, Graham included $351 of machine change-over costs as batch-level costs, and used the number of batches as the cost driver. In her notes she summarized the overhead rate for change-over costs as follows: Total change-over costs are $70,200, calculated as $351 per change-over 200 change-overs. Hence, the overhead rate per batch is $70,200 2,300 batches = $30.5217 per batch, or $0.305217per garment for both stonewash and the proprietary distressed finish. Treating change-over costs in this manner, Graham prepared the cost analysis for the two products that is presented in Exhibit 2. Graham included, for comparison purposes, the benchmark case of using Unit #4 only for stonewash. Grahams Second Pass When Graham completed the analysis in Exhibit 2 for running both stonewash and the proprietary distressed finish, she immediately suspected it was in error. Stonewash had always proven to be a profitable finishing operation in the past, as illustrated by the stonewash-only benchmark scenario in Exhibit 2. Graham quickly identified her problem as the way she had treated the change-over costs. She now decided that these costs should be classified at the product-sustaining level, not the batch 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. Although it was already late in the afternoon, Graham revised the analysis, this time treating the change-over costs in the following manner: Stonewash: $351 per change-over 100 change-overs to the stonewash process = $35,100. $35,100 total change-over costs 180,000 garments = $0.195 per garment. Proprietary distressed finish: $351 per change-over 100 change-overs to the proprietary distressed finish = $35,100. $35,100 total change-over costs 50,000 garments = $0.702 per garment. Using these allocations for change-over costs, Grahams revised cost analysis is shown in Exhibit 3. This revised analysis seemed more reasonable to Graham. The analysis indicated that when running both processes, both were profitable, but the proprietary distressed finish was much more profitable than the stonewashed process on a per-garment basis. It was after 5:00PM by the time Graham showed this analysis to Betty, but Betty was eager to review it immediately. They spent almost an hour going over it line by line, and Graham thought that Betty asked a lot of good questions. Betty was pleased that apparently, she had gotten off on the right foot with Graham. Betty told Graham that the analysis was consistent with her intuition. I suppose this doesn.t address all of Clarks concerns, Betty concluded, but it certainly supports accepting the order and using Unit #4 for both stonewash and the proprietary distressed finish. Graham.s Third Pass At 7:00AM the next morning, Graham was sitting in her office reviewing her notes for her presentation in the upcoming meeting. She was feeling increasingly uncomfortable with her analysis. Minutes before the meeting was to begin, she pulled Betty aside and told her that she needed another day. Betty was surprised, but by now, she had confidence in Grahams abilities, and she reasoned that one more day would not make much of a difference. That afternoon Graham analyzed the problem again, this time by calculating the marginal revenues and costs of accepting the new order. Her analysis is presented in Exhibit 4. First, Graham recorded the incremental revenue from accepting the order. This was easy: it was just the $7 price per garment multiplied by the anticipated demand of 50,000 garments. Then she subtracted the incremental out-of-pocket costs: the direct costs for supplies and shipping; and the overhead costs for set-up, utility expense, materials handling, and product-sustaining activities. Then Graham subtracted the out-of-pocket machine change-over costs ($250 per change-over multiplied by 200 change-overs). Finally, Graham subtracted the opportunity cost associated with the reduction in sales of stonewash garments. Accepting the order from Guess Who Jeans results in lost sales of 70,000 stonewash garments (50,000 lost sales of stonewash garments due to machine-time processing the new finish instead of stonewash, and 20,000 lost sales of stonewash garments due to machine downtime when the machine is being retooled from one finishing process to the other). The marginal cost analysis presented in Exhibit 4 supported accepting the order from GuessWho Jeans. Graham believed that this analysis validated the per-garment information provided by the companys activity-based costing system, and she told Betty that she would present the data in the next days management meeting. REQUIREMENTS Review the Controllers analysis and Exhibits 2 through 4, and complete the following requirements:

1. Describe the machine change-over costs in terms of activity-based costing concepts. What would you identify as the cost driver for these costs? Do you agree with the Controllers ultimate classification of these costs as product-sustaining costs? If not, how would you classify these costs in the cost hierarchy?

2. What nonfinancial issues should be considered in connection with the decision of whether to accept the order from Guess Who Jeans?

3. Put yourself in the role of Frank LAuberge. When Graham presents Exhibits 3 and 4 in the morning management meeting, what questions will you ask? What decision will you make?

4. Discuss the reliability of activity-based costing to lead to the optimal (profit-maximizing) production decision.

5. Do you agree with the Controllers marginal cost analysis? Discuss the reliability of marginal costing to lead to the optimal (profit-maximizing) production decision.

EXHIBIT2 Product Profitability Using ABC and Treating Change-Over Costs as a Batch-Level Cost EXHIBIT 3 Product Profitability Using ABC and Treating Change-Over Costs as a Product-Sustaining Cost Both Products are Run Only Stonewash Stonewash Stonewaslh Proprietary Distressed Proprietary Distressed Finish Finish Stonewash Revenue per unit $2.00 2.000000 7.000000 Revenue per unit 2.000000 7.000000 Direct costs Direct costs Disposable supplies S0.09 Shipping 0.090000 0.900000 0.100000 Disposable supplies Shipping 0.090000 0.100000 0.900000 0.200000 0.10 0.200000 Product-sustaining costs costs 0.750000 0.702000 Administration 0.56 0.750000 er costs 0.195000 Batch-level costs Batch-level costs Utility expense Set-up costs Change-over costs 0.45 0.25 0.450000 0.250000 0.305217 0.450000 0.250000 0.305217 Utility expense Set-up costs 0.450000 0.250000 0.450000 0.250000 Output unit-level costs Output unit-level costs Materials handling Materials handling 0.100000 0.100000 3.352000 3.648000 0.100000 0.100000 Total cost per unit 196277S Total cost per unit 1.55 $ 2.072995 2.955217 Profit (oss) per unit 0.03722 Profit (loss) per unit $0.45 S (0.072995 4.044783 EXHIBIT2 Product Profitability Using ABC and Treating Change-Over Costs as a Batch-Level Cost EXHIBIT 3 Product Profitability Using ABC and Treating Change-Over Costs as a Product-Sustaining Cost Both Products are Run Only Stonewash Stonewash Stonewaslh Proprietary Distressed Proprietary Distressed Finish Finish Stonewash Revenue per unit $2.00 2.000000 7.000000 Revenue per unit 2.000000 7.000000 Direct costs Direct costs Disposable supplies S0.09 Shipping 0.090000 0.900000 0.100000 Disposable supplies Shipping 0.090000 0.100000 0.900000 0.200000 0.10 0.200000 Product-sustaining costs costs 0.750000 0.702000 Administration 0.56 0.750000 er costs 0.195000 Batch-level costs Batch-level costs Utility expense Set-up costs Change-over costs 0.45 0.25 0.450000 0.250000 0.305217 0.450000 0.250000 0.305217 Utility expense Set-up costs 0.450000 0.250000 0.450000 0.250000 Output unit-level costs Output unit-level costs Materials handling Materials handling 0.100000 0.100000 3.352000 3.648000 0.100000 0.100000 Total cost per unit 196277S Total cost per unit 1.55 $ 2.072995 2.955217 Profit (oss) per unit 0.03722 Profit (loss) per unit $0.45 S (0.072995 4.044783