Mother Earth Mulch: Analyzing the Impact of Cost Allocation on Cost Center Performance

The Mulch Company produces a variety of mulch products for ornamental gardens, residential and commercial landscapes, and childrens playgrounds. The Mulch Company operates two divisionsPerma Mulch and Mother Earth Mulch (MEM). Perma Mulch manufactures mulches that degrade very slowly, if at all, from relatively stable materials like gravel, glass, and rubber. The focus of this case, however, is on MEM. MEM produces packaged landscape mulch in two-cubic-foot bags at five manufacturing/packaging plants in the United States. MEM produces mulch from cypress, cedar, pine, and several hardwoods trees. The company also produces mulch from each type of tree in two different qualitiesAll Bark Mulch (AB) and Whole Wood Mulch (WW). The company markets AB mulch as a premium mulch because it decays slower and holds a uniform color for a longer time. The cost analysis in this case focuses on AB and WW as if they were the only two products because processing costs do not differ by the type of tree. Instead, cost differences occur because of the processing requirements of AB vs. WW. In addition to the five manufacturing/packaging plants, MEM operates 20 collection facilities around the U.S. where it collects raw materials and performs some preliminary processing. These facilities collect material from a variety of trees, but the mix of trees varies somewhat by region. Nevertheless, the steps in processing are the same at all collection facilities. Because the collected material is simply sent on to manufacturing/packaging plants after sorting and some preliminary processing, MEM operates its 20 collection facilities as cost centers and its five manufacturing facilities as profit centers. Each collection facility obtains raw material of two basic types including bark and whole wood material. 1. Bark MaterialRegional paper mills and sawmills deliver bark to collection facilities. Before the facility can process logs and pulpwood into paper products or dimensional lumber, it must remove the bark from the logs. Although the bark has little sales value relative to the main products of these industries, companies sell it as a byproduct to MEM, which also saves the mills the cost of landfill disposal. Due to proximity and other factors, landfill disposal is somewhat less costly than delivering bark to MEM, so MEM must pay enough for the bark to motivate supply. 2. Whole Wood MaterialIn the locations of the collection facilities, MEM receives favorable tax treatment from state and local governments in exchange for recycling landscape waste material area residents bring in. WW material also includes tree trimming debris brought in by commercial tree service companies, utility companies, departments of transportation, parks departments, and so on. Some of this debris is in the form of intact limbs, but some goes through a chipping machine before it reaches the collection facilities. MEM pays a nominal amount for the raw material. AB AND WW PROCESSING Process includes sorting, grinding, moving, and shipping: 1. SortingIn a direct-labor intensive process, facilities must unload and sort raw material by type: cypress, cedar, pine, hardwood, organic debris, and inorganic debris. The sorted usable material goes into temporary five-cubic-yard holding bins that operators (forklift drivers) move to the grinding area. a. The facilities sort AB and WW material by type of tree that it came from, but AB requires significantly less sorting than WW because of the nature of the raw material. b. WW material requires more sorting than bark because it can include significant amounts of unusable material. While facilities haul inorganic debris to nearby landfills, organic debris goes into a compost then resold to the community at nominal prices sufficient to cover the cost of the composting operation as well as the cost of disposing the inorganic debris. This feature of operations is one reason MEM gets such favorable tax treatment. c. Usable AB material is sorted in 1/6th of the time to obtain the same quantity of usable WW material. 2. GrindingMachine operators grind and screen sorted raw material up to three times to obtain relatively uniform particle sizes and then load it back into the temporary holding bins. a. Bark, on average, requires a little less grinding than WW. It is usually ground and sifted once or twice depending on how the mills that supply it mechanically removed the bark. b. WW sometimes requires grinding a third time because the long wood fibers in whole limbs are more difficult to reduce to acceptable sizes. Nevertheless, there is no material difference in the average time machine operators need to process AB and WW after sorting it. 3. MovingThe holding bins of ground raw material go into holding areas specific to each type of material. 4. ShippingAs needed by manufacturing and packaging plants, machine operators load raw material into reusable, stackable shipping containers similar to the large commercial dumpsters on construction sites. Each dumpster holds 20 cubic yards of ground raw material. The higher cost that collection facilities must pay for AB material in order to motivate supply is thought to be offset by the increased direct labor cost required to process WW. Therefore, the collection facilities total perunit cost targets are the same for both products. Also, in accordance with contractual agreements, the collection facilities are open 365 days per year. Although the supply of bark material from paper mills is relatively constant, the supply from sawmills is both seasonal and cyclical, moving in tandem with the market for new-home construction. From MEMs perspective, externalities drive volatility in the supply of bark, which means that the MEM price for bark has a limited impact on the quantity supplied. Nevertheless, a minor impact is possible because higher prices might encourage a greater number of smaller mills to enter the bark market rather than choosing alternative means of disposal. MEM has significantly more control over the supply of WW material it receives, and when the supply of AB material increases, MEM decreases the supply of WW by offering a lower price for that material. To some extent, the materials represent alternative uses of capacity because MEM marketing managers have some flexibility in the mix of AB-based vs. WW-based products that they can sell to customers.

WW	AB
Total bins processed	120,000	30,000
Actual price paid per usable cubic foot of input material	$0.15	$0.30
Average direct labor hours per 5 cubic yard bin*	4 hours	???
Average wage earned per full-time equivalent, direct labor employee**	$10 per hour
Collection facility manager salary (each facility has one manager)	$45,000
Total cost of machine operators (average wage = $17.50 per hour)	$2,400,000
Other indirect labor (fixed cost with respect to production)	$70,000
Other collection facility overhead	$985,520
Allocation rate for corporate-level overhead (as percent of direct labor cost)	82%
Collection facilities operated at approximately 95% of capacity. * There are 27 cubic feet in a cubic yard. **Each full-time equivalent employee works 40 hours per week and 50 weeks per year.

Table 1: Year 5 Operating Results for Collection Facilities MEM traces direct labor to AB or WW for costing purposes but allocates the salaries of facility managers and the wages of machine operators as part of total collection facility overhead. Total collection facility overhead also includes some Other Indirect Labor, which is a fixed cost with respect to production levels. MEM has one additional category of collection facility overhead called Other Facility Overhead that includes repairs, utilities, and insurance, but the largest component of this category is depreciation on machinery and buildings computed on a straight-line basis. In addition to facility overhead, MEM allocates each collection facility a share of corporate-level overhead that includes executive salaries as well as centralized support services such as human resources and accounting. Corporate overhead is allocated to divisions based on direct labor cost. The MEM division further allocates its share of corporate-level overhead to collection facilities and manufacturing plants based on their respective direct labor costs. The collection facilities and manufacturing plants further allocate these corporate-level costs to product lines based on their respective direct labor costs. At collection facilities in Year 5, corporate-level overhead was allocated to products at 82% of their direct labor cost. Data from the accounting information system regarding collection facility operations in Year 6 include: The facilities processed 180,000 bins of material50% of which were WW. The price for a usable cubic yard of WW material decreased by 1/3rd, but the premium for each cubic yard of AB material in excess of the price paid for WW material increased from 100% of WW prices in Year 5 to 250% of WW prices in Year 6. As of January 1, Year 6, across the board raises resulted in an increase of 5% in the average wage rates and salaries of all categories at all collection facilities. Total direct labor cost at collection facilities was $4,281,553 USD1. Machine operator cost was $2.8 million. The Other Facility Overhead cost pool totaled $1.155 million. Corporate-level overhead was allocated to products at 89% of their direct labor cost. In February of Year 7, in advance of performance evaluations for division managers, The Mulch Companys chief operating officer (COO) was reviewing cost data for MEMs collection facilities for Year 5 and Year 6 and did not like what he saw. As the companys controller, you will advise the COO on the best interpretation of the data and the implications for performance at the collection facilities.