Case 5-63 Activity-Based Costing, Distorted Product Costs Sharp Paper Inc. has three paper mills, one of which is locate
Posted: Tue Nov 16, 2021 9:12 am
Case 5-63 Activity-Based Costing, Distorted Product
Costs
Sharp Paper Inc. has three paper mills, one of which is located
in Memphis, Tennessee. The Memphis 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 20X1, the Memphis mill produced 120,000 tons of coated
paper and 80,000 tons of uncoated paper. Of the 200,000 tons
produced, 180,000 were sold. Sixty products account for 80% of the
tons 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 20X1, the cost to
produce and sell one ton of LLHC was as follows:
Direct materials:
Furnish (3 different pulps) 2,225 pounds $ 450
Additives (11 different items) 200 pounds $ 500
Tub size 75 pounds $ 10
Recycled scrap paper (296 pounds) $ (20)
Total direct materials $ 940
Direct labor $ 450
Overhead:
Paper machine ($100 per ton × 2,500 pounds) $
125
Finishing machine ($120 per ton × 2,500 pounds) $
150
Total overhead $ 275
Shipping and warehousing $ 30
Total manufacturing and selling cost $1,695
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 tons of output. These rates are then multiplied by
the number of pounds required to produce one good ton.
In 20X1, LLHC sold for $2,400 per ton, 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 vice president, 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: I’m not convinced that solution is the right
one. I know our high-volume products are of high quality, and I’m
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 tons of paper sold.
Yet ...
Kaylin: Jennifer, I hate to disagree, but the $30-per-ton
charge for shipping and warehousing seems reasonable. I know
that our methods 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 ton produced in our
mill passes through our mill shipping department and is either sent
directly to the customer or to our distribution center 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 center. Now, all of the products passing through the
mill shipping department should receive a share of the $2,000,000
annual shipping costs. I’m not convinced, however, that all
products should receive a share of the receiving and shipping costs
of the distribution center as currently practiced.
Ryan: Kaylin, is this true? Does our system allocate our
shipping and warehousing costs in this way?
Kaylin: Yes, I’m 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 center and
those that do not. We should also distinguish between the receiving
and shipping activities at the distribution center. All incoming
shipments are packed on pallets and weigh one ton each. There are
14 cartons of paper per pallet. In 20X1, the receiving department
processed 56,000 tons 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
tons 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 distribution center should
be assigned by using the number of items shipped. In 20X1, for
example, we handled 190,000 shipping items.
Ryan: These suggestions have merit. Kaylin, I would like to
see what effect Jennifer’s 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: I’m willing to compute the effect, but I’d like to
suggest one additional feature. Currently, we have a policy to
carry about 25 tons of LLHC in inventory. Our current costing
system totally ignores the cost of carrying this inventory. Since
it costs us $1,665 to produce each ton of this product, we are
tying up a lot of money in inventory—money 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 20X1:
Tons sold 10
Average cartons per shipment 2
Average shipments per ton 7
Required:
1. Identify the flaws associated with the current method of
assigning shipping and warehousing costs to Sharp’s
products.
2. Compute the shipping and warehousing cost per ton of LLHC
sold by using the new method suggested by Jennifer and Kaylin.
Round rates and the cost per ton to two decimal places.
3. Using the new costs computed in Requirement 2, compute the
profit per ton of LLHC. Compare this with the profit per ton
computed by using the old method. Do you think that this same
effect would be realized for other low-volume products?
Explain.
4. Comment on Ryan’s 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. 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.
Costs
Sharp Paper Inc. has three paper mills, one of which is located
in Memphis, Tennessee. The Memphis 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 20X1, the Memphis mill produced 120,000 tons of coated
paper and 80,000 tons of uncoated paper. Of the 200,000 tons
produced, 180,000 were sold. Sixty products account for 80% of the
tons 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 20X1, the cost to
produce and sell one ton of LLHC was as follows:
Direct materials:
Furnish (3 different pulps) 2,225 pounds $ 450
Additives (11 different items) 200 pounds $ 500
Tub size 75 pounds $ 10
Recycled scrap paper (296 pounds) $ (20)
Total direct materials $ 940
Direct labor $ 450
Overhead:
Paper machine ($100 per ton × 2,500 pounds) $
125
Finishing machine ($120 per ton × 2,500 pounds) $
150
Total overhead $ 275
Shipping and warehousing $ 30
Total manufacturing and selling cost $1,695
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 tons of output. These rates are then multiplied by
the number of pounds required to produce one good ton.
In 20X1, LLHC sold for $2,400 per ton, 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 vice president, 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: I’m not convinced that solution is the right
one. I know our high-volume products are of high quality, and I’m
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 tons of paper sold.
Yet ...
Kaylin: Jennifer, I hate to disagree, but the $30-per-ton
charge for shipping and warehousing seems reasonable. I know
that our methods 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 ton produced in our
mill passes through our mill shipping department and is either sent
directly to the customer or to our distribution center 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 center. Now, all of the products passing through the
mill shipping department should receive a share of the $2,000,000
annual shipping costs. I’m not convinced, however, that all
products should receive a share of the receiving and shipping costs
of the distribution center as currently practiced.
Ryan: Kaylin, is this true? Does our system allocate our
shipping and warehousing costs in this way?
Kaylin: Yes, I’m 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 center and
those that do not. We should also distinguish between the receiving
and shipping activities at the distribution center. All incoming
shipments are packed on pallets and weigh one ton each. There are
14 cartons of paper per pallet. In 20X1, the receiving department
processed 56,000 tons 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
tons 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 distribution center should
be assigned by using the number of items shipped. In 20X1, for
example, we handled 190,000 shipping items.
Ryan: These suggestions have merit. Kaylin, I would like to
see what effect Jennifer’s 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: I’m willing to compute the effect, but I’d like to
suggest one additional feature. Currently, we have a policy to
carry about 25 tons of LLHC in inventory. Our current costing
system totally ignores the cost of carrying this inventory. Since
it costs us $1,665 to produce each ton of this product, we are
tying up a lot of money in inventory—money 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 20X1:
Tons sold 10
Average cartons per shipment 2
Average shipments per ton 7
Required:
1. Identify the flaws associated with the current method of
assigning shipping and warehousing costs to Sharp’s
products.
2. Compute the shipping and warehousing cost per ton of LLHC
sold by using the new method suggested by Jennifer and Kaylin.
Round rates and the cost per ton to two decimal places.
3. Using the new costs computed in Requirement 2, compute the
profit per ton of LLHC. Compare this with the profit per ton
computed by using the old method. Do you think that this same
effect would be realized for other low-volume products?
Explain.
4. Comment on Ryan’s 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. 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.