SUPERIOR CARTRIDGE COMPANY

Mary Stevens, controller of the Superior Cartridge Company, was concerned about the recent financial trends in operating results. Superior Cartridge had been the low-cost producer of BLUE cartridges and BLACK cartridges for printers. Profit margins had traditionally been over 22% of sales.

Several years earlier Aaron Ellsworth, the sales manager, had seen opportunities to expand the business by extending the product line into new products that offered premium selling prices over traditional BLUE and BLACK cartridges. Five years earlier, RED cartridges had been introduced; they required the same basic production technology but could be sold at a 3.33% premium. And last year, PURPLE cartridges had been introduced because of the 10% premium in selling price they could command.

But Stevens had just seen the financial results (see Exhibit 1) for the most recent fiscal year and was keenly disappointed.

The new RED and PURPLE cartridges do seem more profitable than our BLUE and BLACK cartridges, but overall profitability is down, and even the new products are not earning the margins we used to see from our traditional products. Perhaps this is the tougher global competition I have been reading about. At least the new line, particularly PURPLE cartridges, is showing much higher margins. Perhaps we should follow Aaron's advice and introduce even more specialty colored cartridges. Aaron claims that consumers are willing to pay higher prices for these specialty colors.

Ross Collins, the manufacturing manager, was also reflecting on the changed environment at Superior Cartridge:

Five years ago, life was a lot simpler. We produced just BLUE and BLACK cartridges in long production runs, and everything ran smoothly, without much intervention. Difficulties started when the RED cartridges were introduced and we had to make more changeovers. This required us to stop production, empty the vats, clean out all remnants of the previous color, and then start the production of the red ink. Making black ink was simple; we didn't even have to clean out the residual blue ink from the previous run if we just dumped in enough black ink to cover it up. But for the RED cartridges, even small traces of the blue or black ink created quality problems. And the ink for the new PURPLE cartridges also has demanding specifications, but not quite as demanding as for RED cartridges.

We seem to be spending a lot more time on purchasing and scheduling activities and just keeping track of where we stand on existing, backlogged, and future orders. The new computer system we got last year helped a lot to reduce the confusion. But I am concerned about rumors I keep hearing that even more new colors may be introduced in the near future. I don't think we have any more capability to handle additional confusion and complexity in our operations.

Operations

Superior produced cartridges in a single factory. The major task was preparing and mixing the ink for the different-colored cartridges. The ink was inserted into the cartridges in a semi-automated process. A final packing and shipping stage was performed manually.

Each product had a bill of materials that identified the quantity and cost of direct materials required for the product. A routing sheet identified the sequence of operations required for each operating step. This information was used to calculate the labor expenses for each of the four products. All of the plant's indirect expenses were aggregated at the plant level and allocated to products on the basis of their direct labor content. Currently, this overhead burden rate is 300% of direct labor cost. Most people in the plant recalled that not too many years ago the overhead rate was only 200%.

Activity-Based Costing

Mary Stevens had recently attended a seminar of her professional organization in which a professor had talked about a new concept, called activity-based costing (ABC). This concept seemed to address many of the problems she had been seeing at Superior. The speaker had even used an example that seemed to capture Superior's situation exactly.

The professor had argued that overhead should not be viewed as a cost or a burden to be allocated on top of direct labor. Rather, the organization should focus on activities performed by the indirect and support resource of the organization and try to link the cost of performing these activities directly to the products for which they were performed. Stevens obtained several books and articles on the subject and soon tried to put into practice the message she had heard and read about.

Activity-Based Cost Analysis

Stevens first identified six categories of support expenses that were currently being allocated to cartridge production:

She determined that the fringe benefits were 40% of total labor expenses (both direct and indirect) and would thus represent just a percentage markup to be applied on top of direct and indirect labor charges.

Stevens interviewed department heads in charge of indirect labor and found that three main activities accounted for their work. About 50% of indirect labor was involved in scheduling or handling production runs. This proportion included scheduling production orders; purchasing, preparing, and releasing materials for the production run; performing a first-item inspection every time the process was changed over, and some scrap loss at the beginning of each run until the process settled down. Another 40% of indirect labor was required just for the physical changeover from one color cartridge to another.

The time to change over to BLACK cartridges was relatively short (about 1 hour) since the previous color did not have to be completely eliminated from the machinery. Other colors required longer changeover times in setting up; RED cartridges required the most extensive changeover (6 hours) to meet the demanding quality specification for this color.

The remaining 10% of the time was spent maintaining records on the four products, including the bill of materials and routing information, monitoring and maintaining a minimum supply of raw materials and finished goods inventory for each product, improving the production processes, and performing engineering changes for the products.

Stevens also collected information on potential activity cost drivers for Superior's activities (see Exhibit 2) and the distribution of the cost drivers for each of the four products. Stevens next turned her attention to the $10,000 of expenses to operate the company's computer system. She interviewed the managers of the Data Center and the Management Information System departments and found that most of the computer's time (and software expense) was used to schedule production runs in the factory and to order and pay for the materials required in each production run.

Because each production run was made for a particular customer, the computer time required to prepare shipping documents and to invoice and collect from a customer was also included in this activity. In total, about 80% of the computer resource was involved in the production run activity. Almost all of the remaining computer expense (20%) was used to keep records on the four products, including production process and associated engineering change notice information.

The remaining three categories of overhead expense (machine depreciation, machine maintenance, and the energy to operate the machines) were incurred to supply machine capacity to produce the cartridges. The machines had a practical capacity of 10,000 hours of productive time that could be supplied to cartridge production.

Stevens believed that she now had the information she needed to estimate an activity-based cost model for Superior Cartridge. Your task is to assist her in this process.

Questions:

1. Calculate the revised product costs for the four types of cartridges, based on the activity information collected by Stevens.

2. What are the reasons for the deterioration of Superiors profitability?

3. Stevens is considering dropping the Black line because it has lower profitability in Exhibit 1 compared to the Red and Purple line. She believes that a total of $12,000 of overhead cost (excluding the portion of direct labor fringe benefits which varies with the direct labor cost) would be saved if the Black line is dropped. What would be the impact on total operating income if the Black line is dropped?

4. If you were Superiors CEO, what actions would you take to improve performance? Provide concrete action items and discuss how these actions may help in improving performance.