Denim Finishing Company Case
Denim Finishing Company Case
Mrs. Kelsey Bowser using the ABC method decided to use the number of garments as the cost driver of the change-over costs. Nevertheless, I argue that this was not the best possible choice. I will try to defend my point using the following example. Let’s assume that Guess Who Jeans demands 600, not 500 garments per shipment. Although the number of garments changes, the total change-over costs would stay the same, because no additional retooling of the machine would be necessary. The whole change-over process takes 3 hours regarding if the number of garments is 200, 500 or 800. Furthermore, let’s strictly theoretically assume that the company is able to achieve some extra capacity and one batch is now composed of 150 garments instead of 100 garments. Still, although the total number of garments would vastly increase, the change-over costs would be altered only partially. The opportunity cost measured as a lost contribution margin would slightly increase, but the out-of-pocket costs would stay the same, as the wages of the employees and supplies costs will not change.
Thus, it is clear that the number of garments is not the proper cost driver for the change-over costs. In my opinion the number of shipments would be a much better cost driver for the change-over costs. Regarding the number of garments or the number of batches Guess Who Jeans demands every shipment requires the change-over costs to be incurred twice. For instance, if 99 shipments were made, the total change-over costs would equal $351 * 198 = $69,498, because two change-overs ($702) would not have to be undertaken. Thus, the number of shipments clearly drives the analyzed costs. Unlikely the previous example with the number of garments per batch increasing to 150, the number of shipments fully ‘drives’ the change-over costs. Every time the number of shipments rises or falls, the change-over costs change by the full amount of the two per-changeover costs which properly reflect the real situation. Using such a cost driver may be problematic when the allocation of the change-over costs is analyzed. Nevertheless, I argue that those cost should be solely allocated to the propriety denim finishing.
The demand for the stonewashing services exceeds the company’s capacity. Thus, if the Guess Who Jeans’ offer was declined, the company would use the whole capacity for stonewashing. However, if the offer was accepted the stonewashing processes would be somehow ‘interrupted’ by the propriety denim finishing. Each ‘interruption’, and therefore each shipment would require incurring the change-over costs twice. No factor connected with stonewashing ‘drives’ those costs. Regarding the number of batches or garments used in the stonewashing process each shipment necessitates the cost of $702. Therefore, I believe this cost should be associated with every shipment done by Guess Who Jeans. In Appendix A I present the product profitability analysis using the number of shipment as the cost driver.
Moreover, Mrs. Kelsey Bowser claims that the change-over costs should be treated as product-sustaining costs. Nevertheless, I believe her opinion is wrong. I believe these costs should be on the batch level in the cost hierarchy. Hence, I believe the initial analysis undertaken by Mrs. Bowser was correct, although the cost driver she selected was improper. Product-sustaining level costs could be defined as ‘activities that are needed to support an entire product line but are not performed every time a new unit or batch of products is produced’ [Hilton 2010]. Although the first part of the definition applies to the change-over costs, it is clearly not the case when the second part of the definition is concerned. The change-over costs have to be incurred every time the shipments is delivered and the propriety denim finishing has to be done. Therefore, I believe these costs should be rather placed as the batch-level costs in the cost hierarchy.
Batch-level costs are believed to ‘arise from activities performed once for each batch or lot of products’ [Zimmerman 2011]. Since the change-over costs need to be incurred every shipment, placing them at this level in the hierarchy seems reasonable. 2. It is clear that before accepting the proposal several nonfinancial issues have to be considered in order to make a reasonable decision. First, the management should think how accepting the Gues Who offer would affect the relations with the other clients. Since Guess Who requires the Denim Finishing Company not to offer the particular type of finish to other customers, it is very likely that relations with other firms will worsen. The Denim Finishing Company has been cooperating with many companies for a long time. Therefore, those companies may dislike the fact that the new client receives the special treatment, while such benefits could not be observed in their case, even though they have been the customers for ages.
Consequently, the Denim Finishing Company’s reputation may shrink and furthermore the firm may lose some of its customers that it had long term relations established with. Accepting the Guess Who offer, as mentioned before, would require the Denim Finishing Company to offer the certain time of finish exclusively to Guess Who. Hence, the firm would be prohibited from providing other companies with this service. Before making the decision it should be analyzed if that could lead to potential losses in the future. For instance, although cooperating with Guess Who may be beneficial, the potential gains from offering that type of finish to other clients could be higher. If so, the Denim Finishing Company should rather provide the service to other firms. Naturally, before making such a decision it has to be determined if other firms would require the Denim Finishing Company to offer the service exclusively to them, like it is the case for Guess Who. Offering exclusive service to one company may result in other companies’ (not only potential clients as mentioned in the previous paragraph, but also current ones) demands for exclusive treatment.
If other clients, especially those who have been cooperating with the Denim Finishing Company for a long time, realize that it is possible to receive such a special treatment, they would likely claim for it too, as it could give them a competitive advantage over other firms in their industry. Thus, the Denim Finishing Company would undoubtedly face a big problem. It theoretically could increase the prices for the firms that demand exclusive service, but it could lead to losing those clients. Accepting or declining the Guess Who offer may also result in potential conflicts within the firm that have to be considered. For instance, Bruce Farrand who is against the offer may be so determined in defending his point of view that if the offer is accepted, he will decide to terminate his employment.
However, he might be so valuable for the company that the gains from the cooperation with Guess Who would not compensate for the value added by Mr. Farrand. Moreover, some other conflicts could arise in the company after deciding either. Before making the decision it would also be recommended to analyze the potential influence the service offered to Guess Who could have on the machine. Since providing the finish would require constant and often retooling of the machine, it could negatively affect the lifetime of the machine. What is more, it is possible that the quality of services done by the machine would shrink because of those often changes. Hence, the satisfaction among clients could diminish and the high cost of purchasing new machine would have to be incurred soon.
It also cannot be forgotten that the current demand exceeds the firm’s capacity and some of its clients already use services provided by other companies. Thus, if the Denim Finishing Company’s has even less time for stonewashing, these clients can shift to competitors. Finally, it should be estimated what potential nonfinancial benefits could cooperating with Guess Who bring to the Denim Finishing Company. Guess Who is considered to be a company that offers innovative and premium products. Thus, being an important business partner of such a firm could have a positive impact on the Denim Finishing Company’s reputation. Consequently, it could attract new clients and encourage more companies to cooperate with the Denim Finishing Company. Moreover, successful cooperation with Guess Who Jeans could lead to extending the business relations with that company. For instance, it could outsource more of its production to the Denim Finishing Company.
3. If I were Tom Corcoran, I would undoubtedly have a few questions for the controller. First, I would ask about all the problems mentioned in the two previous questions. As mentioned before, I believe that Mrs. Bowser did not place the change-over costs at the right level in the cost hierarchy. Hence, I would like to get to know why she decided to treat them as product-sustaining costs, while there are a lot of arguments supporting the idea to treat them as batch-level costs. Furthermore, the cost driver chosen by Mrs. Bowser is highly doubtful. I would require the explanation how and to what extent in her opinion the number of garments ‘drives’ the change-over costs. Since I believe the number of garments is not the right cost driver, I would ask Mrs. Bowser for some other type of profitability analysis, such as the analysis presented in Appendix A. The analysis presented at the meeting by the controller could be misleading.
Both Exhibit 3 and Exhibit 4 present data that is in my opinion inaccurate. Moreover, as it was analyzed in the second question accepting or declining the offer could lead to multiple nonfinancial outcomes that may play a significant role on the company’s profitability. Hence, I would ask if such factors have been analyzed and if so, what possible impact they may have. I also believe that Tom Corcoran would be most interested in the total profit his company would have under both scenarios. Analyses presented at the meeting, as valuable as they might be, do not contain such information. For instance, they do not include the facility-sustaining costs that the Denim Finishing Company has to incur. Hence, it would be recommended to present Tom Corcoran with the yearly profit the firm may earn. Moreover, I would ask Mrs. Bowser about the accuracy of her assumptions in Exhibit 4. She estimates that the costs of the proprietary process, as well as the price paid by Guess Who Jeans will not change during the year. However, it may not necessarily be the case. The analysis relies on historical costs that may not be appropriate for the future estimations.
Thus, I would like to know if Mrs. Bowser took that aspect into account. Another question would regard the overhead rates of the batch- and unit-level costs. The rates were estimated when only stonewashing was done. However, accepting the offer from Guess Who Jeans would require retaining from using the machine for 600 hours. This could likely result in different overhead costs and consequently different overhead rates. The batch-level utility cost can be particularly problematic. It is ‘driven’ by the machine hours and as previously mentioned the machine is not used for 3 hours before and 3 hours after the shipment. Furthermore, the case makes it unclear whether drying is also performed by the Unit #4. The per-garment utilities cost includes 3 hours for washing and 3 hours for drying.
However, when the change-over is undertaken, the washing is not performed, because the machine cannot be used. Therefore, during the change-over the utilities cost is possibly lower. This is especially important for the opportunity cost analysis. Since the case is lacking information explaining the problem, if I were Tom Corcoran I would like to clarify it. Finally, I strongly believe that it would also be necessary to ask Mrs. Bowser about the facility-sustaining costs. Such costs are ignored in the controller’s analysis. Nevertheless, they still affect the company’s profitability. Hence, I would like to get to know how big those costs are.
Moreover, the facility-sustaining costs could also be somehow influenced by the possible cooperation with Guess Who Jeans. For instance, the security or insurance costs could rise, since the service is supposed to be offered exclusively to that particular client. Therefore, the analysis of the capacity-sustaining costs would also be useful. To sum up, if I were Tom Corcoran I would have many doubts about the controller’s analysis. I would probably ask her to prepare yet another presentation that includes my suggestions. However, if I were to make the decision, I probably would accept the Guess Who Jeans’ offer. The analysis in the Appendix A, although it does not include nonfinancial factors and may not properly reflect all the costs, clearly shows that such a scenario leads to increased profits.
4. Activity-based costing is undoubtedly a useful tool that could help the management to make the optimal decision. It is much more accurate that the traditional costing systems. Distinguishing various activities and determining cost drivers relating to them helps to more precisely allocate the costs. Using one cost driver for all the amount of the overhead could create the situation where the indirect costs are not really ‘driven’ by the particular cost. For instance, although direct labor hours might to some extent determine the value of the overhead, the influence may only be partial, especially regarding certain products. Using various cost drivers for various activities largely eliminates this problem. What is more, selecting particular cost drivers for respective activities enables ‘taxing’ certain activities.
This internal tax system gives an incentive to reduce certain costs and therefore improve the company’s efficiency. For instance, if machine labor hours are chosen as a driver for the production activity there is an impulse to lower the number of machine labor hours which consequently results in decreased value of overhead, lower costs and higher profits. Under Activity-Based Costing the share of costs allocated directly to the products increases. Thus, the company better understand where its overhead costs go to. It enables the firm to identify the products that are not profitable and undertake relevant actions, such as decreasing costs, raising the price or withdrawing the product. However, the cost hierarchy helps to make such decision regarding not only particular products, but also batches and product lines. This undoubtedly allows making decisions that are more profit-maximizing. Moreover, in the ABC the practical capacity is used. Therefore, it is possible to determine the unused capacity. Diminishing the unused capacity is definitely helpful in maximizing the profits of the company.
Hence, Activity-Based Costing provides the management with the information necessary to make optimal decisions. To compare, the traditional costing systems do not give such a possibility. However, the ABC method also has some flaws that may result in making a non-optimal production decision. Some of those disadvantages could be observed in the previous questions. First, the system is believed to be complicated. As noticeable in the first question choosing the proper cost driver for the particular activity might be problematic. Selecting the wrong driver could lead to biased results and consequently the decision that is not profit-maximizing. Furthermore, trying to maintain the cost hierarchy may also be difficult, as shown in the example of Mrs. Bowser from the Denim Finish Company.
The results when the costs were determined as the batch-level where completely different than when they were analyzed to be product-level. Thus, such easily made mistakes could result in a non-optimal decision. Furthermore, as it could be seen in the second question Activity-Based Costing does not include any nonfinancial measures. Thus, even though pure financial values may show that a particular decision is profit-maximizing, it might not necessarily be the case. Other factors, such as e.g. loss of reputation could actually result in decreased profits. Finally, the ABC method requires gathering data from the whole company, often through interviews.
Hence, there is a relatively big possibility that collected data is not perfectly accurate. To sum up, the Activity-Based Costing method is quite reliable tool in making optimal production decisions, especially compared to the traditional costing systems. However, the system has to be carefully planned and implemented, because any mistakes could lead to inaccurate results. Choosing the wrong cost driver and improper assignment of the costs in the cost hierarchy may result in undesired errors. Furthermore, as useful as the ABC is, the management cannot rely solely on financial values provided by the method. Before making the decision all nonfinancial factors have to be considered. Only such a consideration combined with the information supplied by the properly designed and applied Activity-Based Costing system can lead to the optimal production decision.
5. The marginal costing analysis may undoubtedly be a useful tool in making an optimal decision. However, it has to be used carefully, because some of its suggestions may be misleading. This could also be observed in the analysis presented by Mrs. Bowser. The concerns are somehow parallel to the questions raised before. First, the marginal costing analysis does not include any nonfinancial factors. Hence, although the particular activity may seem profitable, it might not necessary be true. Second, the analysis is based on the historical, not the actual costs. The actual costs and price that Guess Who Jeans would be required to pay may differ over the time. Similarly, the application of the overhead depends on the estimates rather than the actual values. Thus, over or underabsorption may happen. Moreover, as mentioned before, after accepting the offer the overhead rates could change. Thus, the costs provided by the controller in the analysis might be inaccurate.
As pointed out in the previous question the case is lacking the information about the possible decrease in the utilities costs during the change-overs. If that was true, the opportunity cost associated with the lost contribution margin on sales of 70,000 stonewashed garments would considerably increase. Considerably, the incremental profit from accepting the new offer would diminish. Another problem with Mrs. Bowser’s analysis, as well as with all the marginal costing analyses is that they do not include the costs that do not change with the unit volume. However, such costs could also influence the decision. Although the analysis presented by the controller shows that accepting the offer would be highly profitable, the figures would not look so vastly appealing if the amount of capacity-sustaining overhead was included in the Exhibit. Furthermore, the presented analysis is only a short-term one. Nevertheless, before making a strategic management the management also has to consider the long-term perspective.
The analysis shows that in the certain year the incremental profits from accepting the Guess Who Jeans’ offer would equal some particular value. The analysis only includes one year though. In the following years the profits could be lower and thus declining the offer could actually be a better decision. For instance, imagine that Guess Who Jeans needs the propriety denim finishing services for its new products that are just to be introduced to the market. The client may expect the high demand for the new product in the first year. However, in the following years the demand for the product, and consequently for the Denim Finishing Company’s services may shrink.
Finally, the marginal costing analysis includes only one-case scenario. It assumes that the projected and the actual number of shipments will be equal. However, it is not certain if that will happen. If some unexpected events happen the marginal costing analysis will not properly reflect the real situation. It cannot be forgotten that the marginal costing analysis is a simple and straightforward tool that can support the decision making. It is particularly useful when two products or divisions are to be compared. Moreover, it can give the management the basis for analyzing the opportunity cost of declining the Guess Who Jeans’ offer. However, the marginal costing analysis should be used carefully. I believe it should be treated as a supportive instrument for decision making rather than the major source of information. Hence, if the controller alter a few things, the analysis could help to make the optimal, profit-maximizing decision.
Subject: Decision making,
University/College: University of Chicago
Type of paper: Thesis/Dissertation Chapter
Date: 30 December 2016
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