Question: Calculate the incremental cash flow The Denim Company would generate by accepting and filling the Guess Who order and producing stonewash jeans when Unit?#4 isn't tied up by Guess Who jeans. That?is, how much better off is The Denim Finishing Company for operating Unit?#4 producing Guess Who jeans and stonewash jeans versus letting Unit?#4 sit idle?(and the firm producing no?jeans)? Assume changeover costs are?$100 per changeover?(and not?$250, as stated in the?case).
Activity-Based Costing and Cost Interdependencies among Products: The Denim Finishing Company Dennis Caplan, Nahum D. Melumad, and Amir Ziv ABSTRACT: A fictional example illustrates how interdependencies among products in the production process, and the costs associated with those interdependencies, chal- lenge the ability of cost accounting systems to generate decision-useful product cost information. The cost interdependency in the current example is a production-line change- over cost that is incurred to retool a machine whenever the production process changes from one product to another. Both marginal costing and full cost activity-based costing (ABC) are employed in an attempt to provide decision-relevant product-level information in connection with the decision to add a new product. Keywords: activity-based costing; cost interdependencies; product profitability analy- sis; change-over costs; setup costs. INTRODUCTION The Morning Let-Down D lane Wiese, recently hired Marketing Director for The Denim Finishing Company, the first person ever to hold that title, was not good at hiding her emotions. Whenever she felt angry or embarrassed, her face turned red, and this morning, she was both. Two months ago, she had left a mid-level marketing position at a large international apparel manufacturer to accept a top- level position at this small contractor laundry, which provides laundering and finishing operations to apparel manufacturers. She made the move because she liked the idea of being a big fish in a small pond. She was also influenced by the enthusiasm and force-of-personality of the president and principal shareholder, Tom Corcoran, who had started the company 15 years earlier. Diane knew that Tom expected a lot from her, and she had anticipated that her announcement this morning would be her first delivery on those expectations. She had proudly outlined in the morning management meeting the details of a possible exclusive contract to provide laundering operations for a well-known designer jeans company, Guess Who Jeans. The designers at Guess Who Jeans had developed and patented a new process to give denim products a novel "distressed" look. Thanks to Diane's hard work, persistence, previous connections, and some luck, she was able to convince the product manager at Guess Who Jeans that he should outsource the new finishing Dennis Caplan is an Assistant Professor at Oregon State University, Nahum D. Melumad is a Professor at Columbia University, and Amir Ziv is a Professor at the Interdisciplinary Center, Herzliya, Israel. We thank Wing Lam and Fred Tse of Levi Strauss & Co., Bjorn Jorgensen, Dennis Bline (associate editor), and two anonymous reviewers for helpful comments and suggestions. We also thank Eyal Sulganik for using the case in the classroom and providing feedback, and Galit Knaz and Mary Kay Reser for research assistance.operation to Denim Finishing. However, Denim Finishing would not be allowed to offer the same exceeds the company's capacity to supply this finish, so the company runs Unit #4 on all three shifts, finish to any other customer. The company had never done work for Guess Who Jeans, so the and some customers source this finish from other laundries as well. contract represented an important "foot-in-the-door." Currently, Denim Finishing provides about a dozen different finishes to four major customers, But now Bruce Farrand, the Operations Director for Denim Finishing, was questioning whether and also provides some of these same finishes to other customers that use the company occasionally. the company even wanted the contract. The price per garment that Diane had negotiated with Guess Four years ago, management adopted an activity-based costing system. Most of the company's costs Who Jeans was $7.00. This was more than twice the revenue that Denim Finishing receives on any are overhead with respect to any one customer or type of finish, and profit maximization requires a other process. Diane attributed the high price not only to her bargaining skills, but to the fact that sound understanding of the cost of providing each finish, because prices are sometimes negotiable, Guess Who Jeans was known as a company focused on getting innovative, premium products to demand exceeds capacity on some equipment, and a variety of finishes are offered. market fast, and perhaps less focused on cost control than some of their competitors. Yet Bruce was expressing doubts about the proposed contract. When they first met, Diane was favorably impressed THE CONTROLLER'S ANALYSIS by Bruce. He was in his early fifties, seemed highly professional, and he had a low-key, friendly Kelsey's First Pass demeanor, and a dry sense of humor. But now Diane was thinking to herself, "Did I misjudge him? Is In the afternoon on the same day as the meeting, Kelsey used Denim Finishing's existing costing he one of those people who feels threatened by his co-workers' successes? Or maybe he isn't system to assess the profitability of accepting the new order for the proprietary distressed finish. For ambitious enough to take on more work for more profits." this analysis, Kelsey decided to ignore facility-sustaining costs and other costs that clearly don't vary Bruce had already emphasized that even though profit margins appeared high for the new finish, with respect to the decision at hand. Following is the relevant information. volume would be relatively low. Bruce continued: Their just-in-time program looks like a good idea-for them-not for us. They want us to drop Operational Data for Unit #4 what we're doing whenever they send us a shipment, and give them one day turnaround on small Capacity: the machine can run approximately 7,500 hours annually, using three shifts daily (a 9- batches. We don't do that currently for our biggest and most loyal customers. We only have one hour day shift, a 9-hour second shift, and a 6-hour night shift), six days per week (the facility closes machine that can be retooled for Guess Who's specialty finish, and that machine is already running at capacity to provide stonewash finish, which we all know is selling like hotcakes. The one day weekly, on a rotating schedule, and any required machine maintenance is scheduled for that retooling costs and machine downtime that we'll incur if we accept the contract will eat into our day). This assumes the machine runs only one finish, so there is no downtime retooling the machine profits. And since the specialty finish is patented by Guess Who, we can't offer it to other for a different finishing operation. customers. Our experience with the new finish, and our efforts to overcome the learning curve, Batch time: three hours per batch, for both the stonewash and the proprietary distressed finishes. won't benefit us elsewhere. This estimate includes time to load and unload Unit #4, but ignores materials-handling time that does When Bruce finished talking, all eyes turned to Tom Corcoran. Diane was prepared to respond point- not tie up the machine. by-point to Bruce's objections, but all of the joy had gone out of her morning Garments per batch: 100 garments per batch for both stonewash and the proprietary distressed Tom was quiet for a long time. Diane wondered whether this was "management by silence." finish. Finally, Tom looked to Kelsey Bowser, the company's Controller, and announced, "We have good If Denim Finishing accepts the order from Guess Who, anticipated demand would be 100 accountants and a good accounting system. Kelsey, can you incorporate Bruce's concerns into shipments of the proprietary distressed finish, with 500 garments per shipment. This implies that five Diane's proposed contract and estimate what the effect on our profits would be if we accept the consecutive batches of the proprietary finish would be processed on each of 100 days during the contract? Please try to have it ready by the end of the week." Kelsey nodded, and the meeting moved year. Diane told Kelsey that she anticipates these shipments would be received on a schedule such on to other business. After the meeting, Diane returned to her office. She wondered whether she that no two shipments could be run back-to-back. Demand for stonewash is effectively unlimited, so should offer to help Kelsey, but she barely knew Kelsey, and she reasoned that her offer might be Denim Finishing could "fill in" on Unit #4 with stonewash whenever the machine was not used for viewed as interfering. She decided to let things go, and see what Kelsey came up with on her own. the proprietary process. Revenue data: The revenue for stonewash is $2.00 per garment, and for the proprietary distressed Background finish is $7.00 per garment. The Denim Finishing Company provides laundering and finishing operations for large apparel Direct costs: Direct costs are effectively variable with respect to the number of garments processed. manufacturers. The company's specialty is taking unwashed denim jeans and other denim products, Disposable supplies for stonewash consist of pumice stone, and for the proprietary distressed finish, and finishing them with a stonewashed, rinsed, bleached, or other specialty finish. The garments are consist of a detergent and also an abrasive natural rock product. Shipping refers to the cost to ship the then shipped back to the manufacturer for warehousing or distribution to customers. The company garments back to the manufacturer. Stated on a per-garment basis, these direct costs are as follows: does not manufacture or market garments, but rather provides an important service to apparel manufacturers who want to outsource this part of the manufacturing process. Proprietary The company operates a single facility. Laundering operations are capital-intensive and require Stonewash Finish Distressed Finish a large investment in industrial-sized washing machines. The facility has six such machines, some of Direct costs which differ along technical specifications. The company operates three shifts daily to fully utilize Disposable Supplies $0.09 $0.90 some of this equipment. One specialty finish is the "stonewashed" look, which is achieved by Shipping $0.10 $0.20 washing garments along with pumice stone. Only one of the company's six machines (Unit #4) can Total $0.19 $1.10 be used for this process. At the present time, demand for stonewash by Denim Finishing's customersOverhead costs: The Denim Finishing Company classies overhead costs into four cost pools, based on the cost hierarchy of output unit-level costs, batchlevel costs, product-sustaining costs, and facility-sustaining costs.I Butch-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 materi- als-handlers receive shipments of garments and hatch them for processing. Aer the garments have been processed through the washing and drying operations, the materials-handlers prepare nished garments for shipment hack 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 nish as for the stonewash nish. This is partly due to the fact that hamh sizes and machine cycle times are the same for both processes, Batch-level and output unit-level cost information is as follows: Overhead Cost Cost Driver Overhead Rate per Garment B etch-level costs 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 $0410 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 X 6 machine hours + 100 garments per batch = $0.45 per garment. Product-Sustaining Casts Product-sustaining costs can be ignored for all processes other than stonewash and the propri- etary nish (the two processes that utilize Unit #4). Product-sustaining costs for these two processes are xed costs that are incurred if that particular nish is run, and are avoidable if the nish is not run. If the nish is run. then these costs are xed. 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 xed 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 nish. The consultant supervises the quality assurance process for stonewash. as well as sourcing of the pumice stone. The procluct
