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Greetings Inc. Greetings Inc.: Activity-Based Costing Developed by Thomas L. Zeller , Loyola University Chicago, and Paul D. Kimmel, University of Wisconsin-Milwaukee The Business Situation Mr. Bums, president of Greetings Inc, created the Wall Decor unit of Greetings three years ago to increase the company's revenue and profits. Unfortunately, even though Wall Decor's revenues have grown quickly, Greetings appears to be losing money on Wall Decor: Mr. Burns has hired you to provide consulting services to Wall Decor's management. Your assignment is to make Wall Decor a profitable business unit. Your first step is to talk with the Wall Decor work force. From your conver- sations with store managers you learn that the individual Greetings stores are very happy with the Wall Decor arrangement. The stores are generating additional sales revenue from the sale of unframed and framed prints. They are especially enthusiastic about this revenue source because the online nature of the product. enables them to generate revenue without the additional cost of carrying inven tory. Wall Decor sells unframed and framed prints to each store at product cost plus 20%. A 20% markup on products is a standard policy of all Greetings inter company transactions. Each store is allowed to add an additional markup to the unframed and framed print items according to market pressures. That is the sell- ing price charged by each store for tnframed and framed prints is determined by each store manager. This policy ensures competitive pricing in the respective store locations, an important business issue because of the intense mall competition While the store managers are generally happy with the Wall Decor products, they have noted a significant difference in the sales performance of the unframed prints and the framed prints. They find it difficult to sell unframed prints at a competitive price. The price competition in the malls is very intense. On average, stores find that the profits on unframed prints are very low because the cost for unframed prints charged by Wall Decor to the Greetings stores is only slightly below what competing stores charge their customers for unframed prints. As a result, the profit margin on unframed prints is very low, and the overall profit cared is small, even with the large volume of prints sold. In contrast, stores make a very good profit on framed prints and still beat the nearest competitor's price by about 15%. That is, the mall competitors cannot meet at a competi- tive price the quality of framed prints provided by the Greetings stores. As a re- sult, store managers advertise the lowest prices in town for high-quality framed prints. One store manager referred to Wall Decor's computer on the counter as a "cash machine for framed prints and a "lemonade stand for unframed prints In a conversation with the production manager, you learned that she believes that the relative profitability of framed and unframed prints is distorted because CA-6 case 2 Cases for Management Decision Making Greetings of improper product conting. She feels that the costs provided by the company's traditional job order costing system are inaccurate. From the very beginning she has carefully managed production and distribution costs. She explains Wall Dcor is essentially giving away expensive framed prints, and it appears that it is charging the stores too much for unframed prints "In her office she shows you her own product casting system, which supports her point of views Your tour of the information technology (IT) department presided additional insight as to why Wall Decor is having financial problems. You discovered that to keep the website running requires separate computer servers and several infor mation technology professionals. Two separate activities are occurring in the technology area. First, purchasing professionals and IT professionals spend many hours managing thousands of prints and frame and matting materials. Their tasks include selecting the prints and the types of framing material to sell. They also must upload, manage, and download prints and framing material onto and off of the website. The IT stall tells you much of their time is spent with framing and matting material. Only a highly skilled IT professional con properly scana print and load it up to the site so that it graphica represents what the print will look like when properly matted and framed. In addition, you discover that a different team of IT professionals dedicated to optimizing the operating performance of the website. These costs are classified zs manufacturing overhead because a substantial amount of work is required to keep the site integrated with purchasing and production and to safeguard Wall Decor's assets online. Most time-consuming is the effort to dieselop and maintain the site so that customers can view the prints as they would appear either un framed or framed and malted A discussion with the IT professionals suggests that the time spent develop ing and maintaining the site for the unframed prints is considerably less than that required for the framed prints and in particular for the framed and matted prints. Developing and maintaining a site that can display the unframed prints is relatively straightforward. It becomes more complicated when the site must allow the customer to view every possible combination of print with every type of steel frame, and immensely more complicated when one considers all of the possible wood frames and different matting colors. Obviously a very substantial portion of the IT professionals time and resources is required to present the over 1.000 different framing and matting options Based on your preliminary findings you have decided that the company's ability to measure and evaluate the profitability of individual products would be improved if the company employed an activity-based costing (ABC) system. As a first step in this effort, you compiled a list of costs, activities, and values. Your work consisted of taking the original manufacturing overhead cost ($375.200 provided in Case 1) and allocating the costs to activities. You identified four activities: picking prints inventory selection and management (includes general management and overhead), website optimization and framing and matting cost (includes equipment, insurance, rent, and supervisor's salary) The first activity is picking prints. The estimated overhead related to this activity is $30,600. The cost driver for this activity is the number of prints. It is expected that the total number of prints will be 102.000. This is the sum of 80,000 unframed, 15,000 steel framed, and 7.000 wood-framed illustration CA 2 Information for at Activity Picking prints Cost Driver Number of prints Estimated Overhead $30,000 Expected Use of Cost Driver (80.000 - 15.000 7.000) 102.000 prints CA-8 Greetings case 2 Cases for Management Decision Making The second activity is inventory sclection and management. The estimated overhead related to this activity is $91,700. The cost driver for this activity is the number of components per print item. An unframed print has one component a steel framed print has two components (the print and the frame and a wood framed print has the components (the print, the mat, and the framel. The total number of components is expected to be 131,000 llustration CA 2-2 information for activity 2 Estimated Overhead $91.700 Activity Cost Driver Inventory Number of selection and components management Print (1) Print and m2) Print mat and me Expected Use of Cost Driver Pris: 50.000 components Prande 15.000 30.000 components Pristund me 7.000 21.000 The 1000 components The third activity is website optimiration. The total nehead cost related to website optimization is expected to be $129.000. It was difficult to identify a cost driver that directly related website optimization to the products. In order to re flect the fact that the majority of the time spent on this activity related to framed prints. you first split the cost of website optimization between umframed prints and framed prints. Based on your discussion with the IT professionals, you deter mined that they spend roughly one-fifth of their time developing and maintain ing the site or unframed print and the other for fifths of their time on framed prints, even though the number of framed prints sold is substantially less than the number of unframed prints. As a consequence, you allocated $25.800 of the one lead costs related to website optimization to unramed prints and 5103,200 to framed prints. Your contemplated having three categories Canframed, Neel framed, and wood-framed with matting), but chose not to add the additional refinement. Ilustration CA 23 Information for activity Cost Driver Estimated Overhead Expected Lise of Cost Driver Activity Website optimi Unfred $ 200 Namber of peints a capacity Number of parts al capacity Uamed prints 100.000 pl Foamed and Framed 5105.300 25.000 print 10.000 Wel,000 wood) Once the $129.000 of the third activity was allocated across the two broad product categories, the number of prints at porting capacity was used as the cost driver. Note that operating capacity was used instead of expected units sold The overhead costs related to website optimization are relatively lined because the employees are salaried. If a fixed cost is located using a value that varies from period to period (like expected sales), then the cost per unit will vary from period to period. When allocating fixed costs it is better to use a base that does not vary as much, such as operating capacity. The advantage of using operating capacity as the base is that it keeps the fixed costs permit stable over time CAS case 2 Cases for Management Decision Making Greetings The final activity is framing and matting. The expected overhead costs related to framing and matting are $123.900. None of this head at should be allo cated to unframed prints. The costs related to framing and matting are relatively fixed because the costs relate to equipment and other costs that do not ay with sales volume. As a consequence, like website optimization, you chose to hase the Bost driver on levels at operating capacity rather than at the expected sales level The cost driver is the number of components Steel framed prints have to com ponents (the print and frame and wood framed prints have three components the print, mat, and frame. The total components at operating capacity would be steel frame 32,000 or 16.000 X 2) and wood frame 27.000 (or 9.000 x 3.000) Hlustration CA 24 Estimated Overhead $123.900 Activity Framing and nating equipment , incent and up Labor Cox thriver Number wents apacity Expected Use of Cost Driver Printre 16.000 X 2 52.000 components a capacity Printmat and frame: 9.000 27,000 components capacity Tocal - 59.000 components To summarize the owerhead costs and cost drivers used for each product are expected to be illustration CA 25 Sumary of and costs Steel Wood- Frame Framed No with Unframed Matting Matting Total Cost Driver Naux of Overhead Com Activity 1. Picking NO.000 15.000 7.000 2.000 $0.00 to od 0.000 100.000 21.000 131.000 100 000 91.700 250 2. Inventory Numbered clection and comports manat 3. Website Num optimization prita capacity 4. Frami and Number of matti components lady 1000 9.000 25.000 103200 32.000 27,000 59.000 121900 $375300 Instruction Answer the following questions 1. Identity wore was actibus contine em may be appropriate for Wall DA 2. Compute the achieved head for each of the four activities Discuss the implications of using operating city as the cat driver rather than the expected units old when allocating fixed overhead cost 4. (a) Allocate the overhead to the three product categories unframed prints, so framed print and wood-framed prints with matting with the estimate of the expected units solis correct and the actual amount of overhead incurred equaled the estimated amount of $375.200 b) Calculate the total amount of overhead allocated. Explain why the of 5375.200 was not allocated, een though the estimate of WOW are the implications of this for man