CASE 6-27 ACTIVITY-BASED COSTING, DISTORTED PRODUCT COSTS

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Sharp Paper Pty Ltd has three paper mills, one of which is located in Perth, Western Australia. The Perth 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 2016, the Perth mill produced 120 000 tonnes of coated paper and 80 000 tonnes of uncoated paper. Of the 200 000 tonnes produced, 180 000 were sold. Sixty products account for 80% of the tonnage 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 2016 the cost to produce and sell one tonne 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 tonnes of output. These rates are then multiplied by the number of kilograms required to produce one good tonne.

In 2016, LLHC sold for $2400 per tonne, 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 director, 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: Im not convinced that solution is the right one. I know our high-volume products are of high quality, and Im 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 tonnes of paper sold. Yet . . .

KAYLIN: Jennifer, I hate to disagree, but the $30-per-tonne 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 tonne produced in our mill passes through our mill shipping department and is either sent directly to the customer or to our distribution centre 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 centre. Now, all of the products passing through the mill shipping department should receive a share of the

$2 000 000 annual shipping costs. Im not convinced, however, that all products should receive a share of the receiving and shipping costs of the distribution centre as currently practised.

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

KAYLIN: Yes, Im 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 centre and those that do not. We should also distinguish between the receiving and shipping activities at the distribution centre. All incoming shipments are packed on pallets and weigh one tonne each (there are 14 cartons of paper per pallet). In 2016, the receiving department processed 56 000 tonnes 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 tonnes 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

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ACTIVITY-BASED COSTING

distribution centre should be assigned by using the number of items shipped. In 2016, for example, we handled 190 000 shipping items.

RYAN: These suggestions have merit. Kaylin, I would like to see what effect Jennifers 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: Im willing to compute the effect, but Id like to suggest one additional feature. Currently, we have a policy to carry about 25 tonnes of LLHC in inventory. Our current costing system totally ignores the cost of carrying this inventory. Since it costs us $1665 to produce each tonne 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 2016:

REQUIRED:

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

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

3. 3 Using the new costs computed in requirement 2, compute the profit per tonne of LLHC. Compare this with the profit per tonne computed by using the old method. Do you think that this same effect would be realised for other low-volume products? Explain.

4. 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.

5. 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) $ 450 1112 kilograms Additives (11 different items) 100 kilograms 500 Tub size 38 kilograms 10 Recycled scrap paper (148 kilograms) (20) 940 Total direct materials $ 450 Direct labour Overhead: Paper machine ($100 per tonne x 1250 kilograms) Finishing machine ($120 per tonne x 1250 kilograms) $125 150 $ 275 Total overhead $ 30 Shipping and warehous ing $1 695 Total manufacturing and selling cost Tonnes sold 10 Average cartons per shipment 2 Average shipments per tonne 7