Activity Based Costing Draft

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ABSTRACT
This case details a fictional denim processing plant providing the service of custom finishing to denim pants for original manufacturers. The case is a lesson in how interdependencies among products in the production process and the costs associated with those interdependencies can be cost analyzed for management decisions. The retooling of a finishing machine change-over production from an existing stonewash process to accomplish a proposed distressed finishing process for a new customer, is the cost interdependency studied. We explain how marginal costing and full cost activity-based costing (ABC) are used by the controller to present management product optimal (profit-maximizing) production decisions on the proposed contract.

The Denim Finishing Company provides laundering and special finishing of denim pants for the original manufacturer. Their specialty is converting unwashed denim jeans and other denim products a variety of finishes including bleached, stonewashed, rinsed, and other finishes.

The factory utilizes six machines with differing technical specifications per product. Only one machine can accomplish the “stonewash finish” using pumice stones in the machine, and running at capacity, is not able to fulfill the entire current customer demand for this product. It currently is running at maximum capacity on three shifts.

Denim Finishing Company’s new Marketing Manager in the case, Diane, proposed accepting a new customer contract from Guess Who Jeans for a proprietary custom finish that would yield gross revenue of $7.00 per garment for 100 shipments of 500 garments per shipment. They would require finishing on the Unit 4 machine, after a changeover process on the machine converting it from stonewash finishing to the Guess Who “distressed” finishing. This revenue per garment is much higher than current revenue per garment for the stonewashed finish. Most of the company’s costs are overhead with respect to any one customer or finish, and profit maximization requires understanding the cost of providing each finish, because prices are sometimes negotiable, demand exceeds capacity on some equipment, and a variety of finishes are offered. The Operations Manager, Tom, is concerned that the cost of labor and downtime in equipment changeover, low volume of the distressed finish vs. the stonewash finish, and the fact that the distressed service could not be utilized for any other customer would lower profitability.

The CEO has tasked the Controller, Kelsey, with performing a cost analysis in order for management to make a decision on whether accepting the new contract will be profitable. In her first analysis, Kelsey used the company’s existing costing system to assess the new order’s profitability. She decided to ignore facility sustaining costs and other costs that don’t vary in respect to the current decision. Following is the data used in her analysis: Unit #4 Operational Data:

Capacity| Batch time| Garments/batch| Revenue| Direct Costs Stonewash| Direct Costs Distressed| 7500 hours annually| 3 hours/batch| 100/batch| Stonewash=$2.00 per garment| Supply=.09| Supply=.90| | | | Distressed=$7.00 per garment| Shipping=.10| Shipping=.20| | | | | Total = $.19| Total=$1.10|

Direct costs are variable with respect to the number of garments processed. Overhead costs are based on the cost hierarchy of output unit-level cost, batch-level cost, product-sustaining costs, and facility-sustaining costs.

In Exhibit 1, provided at end of text, Kelsey analyzed per unit product sustaining costs for both stonewash only and for using Unit #4 for both finishes. This analysis showed costs of $.56 per unit of stonewash only batches and $.777 per unit for batches of both finishes. The changeover costs to convert the machines included labor and disposable supplies that would be avoided if there were no changeover. For changeover costs, she also reasoned opportunity costs...
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