Mr. Sami Sultan, Chairman of Sky Plastics, was studying a schedule showing the product costs for each of the company's three plastic water containers. He had been thinking of how to increase the company's exports while facing the international competition for plastic water containers. Usually, Sami did not spend a lot of time to review company's performance reports. Since profits were being made, Sami believed that accounting was the responsibility of the financial director and his staff. In recent months, however, Sami has started to pay much attention to the financial and management of the company's products. This has been mainly due to his understanding that under the current business environment companies should pay much attention to the cost of products and services offered to their customers. Recently, he had participated in several workshops on cost management in Dubai and knew that companies need to manage costs and focus on increasing efficiency and effectiveness in order to stay in market and grow its business. Sami learnt that senior managers must understand costs and revenues of company operations and should never rely on accountants only. With this understanding, Sami has been talking to the financial director about increasing the profitability of the company's product lines. Background Sky Plastics was established in the 80s for the purpose of manufacturing high quality plastic pipes. The company is medium sized family business. The Company's head office and factory are located in Jebel Ali, the major business district in Dubai. Fadi Sultan, the current chairman's father, founded the company. Fadi had worked as a university president for over 10 years and had wanted to start his own business. He started his business with a small amount of money which he saved from his previous work and over the years the company grew rapidly from a small factory to an export oriented business. The company specializes in the production of high quality plastic pipes. The company started producing plastic water containers early 2000. A separate manager heads each of these product lines under the direct supervision of the operations director. The company enjoys an international reputation as a producer of high quality plastic pipes. While the company's turnover is over US 10 million in 2003, its major export market is Russia. The company also produces plastic pipes for several famous brand names in Europe. At the end of 2003, Fadi Sultan retired from his chairman position and his son Sami Sultan became the chairman. Sami started working as the director of marketing following his graduation from business school in 1997. He was studying the expansion of the company's export product lines and was looking for growth opportunities. After considerable market research, the company started to produce and export three types of plastic water containers in March 2004. Cost Management at Sky Plastics The company has been setting its prices using market-based systems. Sami knew that the marketing department has been studying the prices of similar products available in the marketplace. The accounting department used that information in setting the prices of company's products. Sami, however, decided to follow a managerial approach different from his father's approach. He believes that senior managers should be involved in every aspect of the company's operations including operational and management control. Sami knows that the company is profitable, but he is interested in knowing about the profitability of each individual product line. Particularly, he wants to know about the cost information of the company's plastic water containers line, as he was not sure whether the prices set by the accounting department were correct. the water containers' line. Hany joined the company in May 2006 after a long employment as the chief Two days ago, Sami met the financial director, Mr. Hany Sameer to find out the price-setting procedures for accountant in one of the pioneering plastic manufacturers in Dubai. He was popular for refining the cost accounting system at the previous plastic company. Sami thought Hany would be ideal for restructuring the cost accounting system at Sky Plastics and shared with him his concerns about the pricing strategy of plastic water containers' product line. Sami is searching for ways to improve the export market share of these plastic water containers. He thinks that reducing the price of these products may lead to an increase in the market share. The prices of the three products are as follows: Sales price Product A Product B Product C $ 50.00 $104.50 $ 90.50 Hany started to prepare an analysis of unit product costs for each of the three product lines, as he is sure such information will be useful in determining any adjustments in the product prices. Hany also revealed his intention about refining the existing cost accounting system. He told Sami that the company has been using a plantwide overhead rate system based on direct-labor-based costs, which is not very reliable in providing accurate information for making good decisions. Few days later, Hany met Sami and gave him a schedule showing his calculations of product costs for each product, under the existing system (Table 1) and informed Sami that he was surprised to know that the company's pricing strategy is based on market prices. Hany told Sami he wanted to use Activity-Based Costing (ABC) system as thus would provide better and more accurate cost information than the direct-labor-based costing system. Table 1: SKY PLASTICS Calculation of Product Costs: Direct-Labor-Based Costing System Product A Product B Product C Number of direct labor hours Single plan-wide factory overhead rate 40,000 $8/dlh 20,000 $8/dlh 140,000 $8/dlh Total factory overhead $ 320,000 $160,000 $ 1,120,000 Number of units Overhead cost per unit 25,000 $12.80 5,000 50,000 $22.40 $32.00 Direct labor cost per unit 20.00 22.00 32.00 Direct materials cost per unit 26.50 21.50 17.00 Total cost per unit $59.30 $85.50 $61.40 Sami was very annoyed by the results of the cost analysis as the company was selling Product A for $50 and it costs the company $59.30 to produce those products. Sami requested Hany to prepare a detailed cost analysis of the company's entire product line but first he wanted to know the cost information for the plastic water container product line. Sami was worried that other products might also have higher costs than their selling prices and decided to investigate the situation. He spent some time alone in his office thinking of how to solve this problem, which has been existing in the company over many years. Finally, he gave up and hoped that Hany would come up with a good solution. Hany requested Sari Sunnar, the assistant accountant, to prepare an analysis of activities and their relevant cost for plastic water containers. Sari spent a couple of days in collecting relevant data from company's records and prepared a schedule showing the activity-base usage quantities and units produced for cach of the three products (Table 2). He also prepared a schedule of the annual overhead costs for the plastic water containers (Table 3) and a schedule of four major activities and their costs for the Production Support Department (Table 4). Table 2 ACTIVITY DATA BY PRODUCT Products Number of Units Product A 25,000 Direct Labor Hours 40,000 Machine Setups Production Orders Inspections Material Requisition 100 100 30 200 Product B 5,000 20,000 40 40 15 250 Product C 50,000 140,000 20 20 5 50 Total 80.000 200,000 160 160 50 500 Table 3 FACTORY OVERHEAD COSTS FOR PLASTIC WATER CONTAINERS Production Support Department Production (factory overhead only) Total cost Factory Overhead $1,200,000 400.000 $1,600,000 Table 4 PRODUCTION SUPPORT DEPARTMENT COSTS Production Support Activities Setup Production control Quality control Materials management Total cost Cost $400,000 300,000 300,000 200,000 $1,200,000 Later on that day, Sami met with Hany to know the progress of the cost analysis. "Hany, I'm very upset that we are losing money from plastic water containers. Have you found any more useful information about their accurate product costs?" asked Sami. "I believe that over the coming 2 days we can find out the accurate product costs of water containers as we are already on the way to do an analysis of an Activity-Based Costing," replied Hany. "Activity Based Costing is a very accurate method of costing. Your company have allocated factory overhead based on a single plantwide rate method using direct labour hours. I recommend that the company allocates factory overhead using the actual usage rate of those facilities by each product," suggested Hany. He explained that ABC would produce more accurate costs of the three products than the labour-based costing would. Sami asked Hani, "Do you think that we can adopt ABC completely"? "In my previous work, we implemented an ABC system and within few months the company saved a huge amount of money. ABC is considered an important management advisory system and it helped us eliminate a large number of non value adding activities", replied Hani. Sami returned to his office with the schedules Hany had given to him. He wanted to know more about he ABC system. He thought that Hany would be a real asset to the company. Sami tried to calculate the cost for each product using the cost schedules given by Hany but found it complicated and time consuming. He is Finding it difficult to wait to hear about the ABC analysis from Hany. Questions magine that Sami has visited you and asked for your help. Following are the questions Sami had listed: 1. (5 points) Show how the factory overhead cost per unit for products A, B, and C under the single plantwide factory overhead method have been calculated in Table 1 2. (20 points) Using information given in this case and knowing that the following activities consume support department resources: 1. Machine Setup 2. Production Control 3. Quality Control 4. Materials Management 5. Production Overhead costs and given the following activity drivers (cost drivers) for each of the above activity area, determine the factory overhead cost for products A, B, and C based on activity-based costing. ACTIVITY POOL Activity Area Machine Setup Production control Quality control Materials management Production Overhead costs Cost Driver Setups Production orders Inspections Requisitions Direct labor hours 3. (10 points) Calculate the product cost for each product using the Activity Based costing method, 4. (10 points) What you conclude about the ABC versus costing based on direct labour hours only? 5. (5 points) What changes do you advise management make to Sky Plastics' pricing strategy?