Costing System at Plastim Corporation

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Case study

Costing System at Plastim Corporation

Introduction:

Plastim Corporation manufactures lenses for rear (tail) lamps of automobiles. The lens, made from black, red, orange or white plastic, is the part of the lamp visible from the outside. Lenses are made using injection molding. The molding operation consists of injecting molten plastic into a mold to give the lamp its desired shape.

Under its contract with Giovanni Motors, a major automobile manufacturer, Plastim makes two types of lenses – a complex lens, CL15, and a simple lens, S3. The complex lens is a large lens with special features such as multicolor molding (where more than one color is injected into the mold) and complex shapes that wrap around the side of the car.

The sequence of steps to design, produce, and distribute lenses, whether simple or complex is as follows.

1. Design of products and processes. Design the molds from which the lenses will be made and define the processes needed ( details of manufacturing processes)

2. Manufacturing operations. The lenses are molded, finished, cleaned, and inspected.

3. Shipping and distribution. Finished lenses are packed and sent to Giovanni Motors.

Plastim is operating at capacity and incurs very low marketing costs. Because of its high-quality products, Plastim has minimal customer-service costs. Plastim’s business environment is very competitive with respect to simple lenses. At a recent meeting, Giovanni’s purchasing manager indicated that a new competitor, who makes only simple lenses, was offering to supply the S3 lens to Giovanni at a price of around $53, well below Plastim’s price of $63. Unless Plastim lowered its

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selling price, it would be in jeopardy of losing Giovanni’s business for the simple lenses, similar to S3, for the upcoming model year. Plastim’s management was very concerned about this development. The same competitive pressures did not exist for the complex lens, which Plastim currently sells to Giovanni at a price of $137 per lens.

Plastim’s management had various alternatives open to it:

1. Plastim could give up the Giovanni business in simple lenses if it were going to be very unprofitable. OR

2. It could reduce the price on the simple lens and either accept a lower margin or aggressively seek to reduce costs.

But first management needed to understand what it costs to make and sell the S3 and CL5 lenses. To guide its pricing and cost management decisions, Plastim’s managers assign all cost, both manufacturing and non manufacturing, to the S3 and CL5 lenses. To cost products, Plastim currently uses indirect-cost-pool job costing system. The steps are as follows.

1. Identify the chosen cost object: ( Simple 60,000 lenses and 15,000 complex CL 5 lenses)

2. Identify the Direct costs of the lenses – direct materials and direct manufacturing labor

3. Plastim uses direct manufacturing labor-hours as the only allocation base to allocate all indirect costs to S3 and CL 5. Most of the indirect costs consist of salaries paid to supervisors, engineers, production support, and maintenance staff that support direct manufacturing labor.

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Product Costs at Plastim’s Inc. with existing Single Overhead – Cost pool.

60,000 Simple lenses (S3) 15,000 Complex lenses (CL5)

Total Per unit Total Per unit TotalDirect materials $1,125,00

0$18.75 $675,000 $45.00 $1,800,000

Direct labor 600,000 10.00 195,000 13.00 795,000Total direct costs $1,725,00

028.75 870,000 58.00 2,595,000

Indirect costs allocated

1,800,000 30.00 585,000 39.00 2,385,000

Total costs $3,525,000

58.75 $1,455,000 $97.00 $4,980,000

Plastim’s management begins investigating why the S3 lens costs $58.75, well above the $53 price quoted by Plastim’s competitor. Are Plastim’s technology and processes inefficient in producing and distributing the simple S3 lens? Further analysis indicates that this is not the reason. Plastim has years of experience in manufacturing and distributing lenses like S3.Because Plastim often makes process improvements, management is confident that Plastim’s technology and processes for making lenses are not inferior to those of its competitor. Management is pleasantly surprised to learn that Giovanni Motors considers the prices of CL5 lenses to be very competitive. Even more puzzling is that, even at these prices, Plastim earns very large margins on the CL5 lenses.


Total Per unit Total Per unit TotalRevenue $3,780,00

0$63.00 $2055,000 $137.00 $5,835,000

Costs 3,525,000

58.75 1,455,000 97.00 4,980,000

Operating Income $255,000 4.25 600,000 40.00 855,000Operating Income ÷Revenue

6.75% 29.20%

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Plastim’s managers are surprised that the margins are low on S3 product where it has strong capabilities, while the margins are quite high on the newer, less established CL5 products. Since they were not deliberating charging a low price for S3, they wonder if the cost system over costs the simple S3 and under costs the complex CL5 lens.

Refining a cost system

A refined costing system results in a better measure of the non uniformity in the use of an organization’s resources by jobs, products and services. Increased competition and advances in information technology have accelerated these refinements. Three guidelines for refining a costing system are:

1. Direct-cost tracing. Classify as direct costs as many of the total costs as is economically feasible.

2. Indirect-cost pools: Expand the number of indirect-cost pools until each of these pools is homogeneous. In a homogeneous cost pool, all costs in the cost pool have the same or similar cause-and-effect relationship.

3. Cost-allocation base. Identify the preferred cost-allocation base for each indirect-cost pool.

Activity-Based Costing Systems

ABC systems calculate the costs of individual activities and assign costs to cost objects such as products and services on the basis of the activities undertaken to each product or service.

Plastim’s team identifies seven major activities.

1. Design products and processes2. Set up molding machine to ensure mold is properly held in place and parts

are properly aligned before manufacturing starts.3. Operate machines to manufacture lenses.4. Maintain and clean the mold after lenses are manufactured.

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5. Set up batches of finished lenses for shipment6. Distribute lenses to customer sites.7. Administer and manage all processes at Plastim

ABC systems emphasize on individual activities by focusing on the set up activity. Setups frequently entail trial runs fine tuning, and adjustment. The resources needed to set up the machines depend on the complexity of the manufacturing operation. Complex lenses require more set ups resources than do simple lenses. Furthermore, complex lenses can be produced only in small batches because the mold needs to be cleaned more often.Set up data for the simple S3 lens and the complex CL5 lens are as follows:

Simple S3

Complex CL5

Total

1 Quantity of lens produced 60,000 15,0002 Number of lens produced per batch 240 503 Number of batches = (1) ÷ (2) 250 3004 Set up time per batch 2 hours 5 hours5 Total set up hours = (3)×(4) 500 hours 1,500 hours 2,000 hours

Plastim identifies the total setups (consisting mainly of allocated costs of process engineers, supervisors, and setup equipment) as $300,000. The following table shows how setup costs are allocated to the simple and complex lenses using direct manufacturing labor-hours and setup-hours respectively as the allocation bases.

Cost allocation bases Simple S3 lens Complex CL5 lens Total

Direct labor hour $226,415* $ 73,585 $300,000

Set up hours $ 75,000! $225,000 $300,000

*$7.54717 × 30,000, $7.54717 × 9,750

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!$ 150 × 500, $ 150 × 1,500

Some costs can be directly identified with a particular activity. For example, salaries paid to design engineers are directly identifies with the design activity. Other costs need to be allocated across activities. However, the allocation base chosen are as follows.

Activity(1)

Cost Category(2)

Total costs (3)

Allocation base(4)

Allocation rate(5) =

(3) ÷ (4)Design Product-

sustaining$450,000 100 parts times

square-meter area$4,500 per part times

square-meter area of mold

Set up Batch $300,000 2,000 setup hours $150 per setup-hour

Manufacturing operations

Output units $637,500 12,750 molding- machine hours

$50 per machine hour

Shipment set up

Batch $81,000 200 shipments $ 405 per shipment

Distribution Output units $391,500 $67,500 cubic meters

$5.80 per cubic meter

Administration Facility sustaining

$255,000 39,750 direct labor hour

$6.4151 per direct labor

hour

The key point here is that all costs do not fit nicely into activity categories. Often costs may need to be first allocated to activities before the costs of the activities can be allocated to products.

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Implementation of Activity-Based Costing at Plastim

The three guide lines for refining costing system are

1. Increasing direct cost tracing2. Creating homogeneous in-direct cost pool3. Identifying cost allocation basis (That have cause-and-effect relationship

with costs in the cost pool)

Product Costs under Activity-Based Cost Systems

60,000 15,000

Simple Lenses (S3) Complex Lenses (CL5)

Total Per Unit

Total Per Unit

Total

Direct CostsDirect materials $1,125,000 $18.75 $675,000 $45.00 $1,800,000Direct labor 600,000 10.00 195,000 13.00 795,000Direct maintenance

120,000 2.00 150,000 10.00 270,000

Total direct costs 1,845,000 30.75 1,020,000 68.00 2,865,000Indirect CostsDesign costs 135,000 2.25 315,000 21.00 450,000Setup costs 75,000 1.25 225,000 15.00 300,000Manufacturing operations costs

450,000 7.50 187,500 12.50 637,500

Shipping set up costs

40,500 0.67 40,500 2.70 81,000

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Distribution activity

261,000 4.35 130,500 8.70 391,500

Administration activity

192,453 3.21 62,547 4.17 255,000

Total indirect costs

1,153,953 19.23 961,047 64.07 2,115,000

Total costs $2,998,953 49.98 $1,981,047 $132.07 $4,980,000Comparing Alternative Costing systems

1. Existing Single Indirect-Cost Pool System



0$63.00 $2055,000 $137.00 $5,835,000

Costs 3,525,000

58.75 1,455,000 97.00 4,980,000


6.75% 29.20%

2. ABC System



0$63.00 $2055,000 $137.00 $5,835,000

Costs 2,998,953

49.98 1,981,047 132.07 4,980,000


20.66% 3.70%

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Activity Based Management

1. Product and pricing Management

The ABC system gives insight into the cost management structures for making and selling diverse products. As a result, management can make better product and pricing decisions. For example, the ABC system indicates that Plastim can reduce the price of S3 to the $53 range and still make a profit, because the ABC cost of S3 is $49.98. Without the ABC information, Plastim management may have erroneously concluded that it would incur an operating loss on the S3 lens at the $53 price. This incorrect conclusion may have caused Plastim to reduce its business in simple lenses and focus on complex lenses, where its existing single-indirect pool system indicates it is very profitable.

2. Cost reduction decisions

Manufacturing and distribution personnel use ABC systems to focus on cost reduction efforts. Managers set cost-reduction targets in terms of reducing the cost per unit of the cost-allocation base in different activity areas. For example, the supervisor of the distribution activity area at Plastim could have a performance target of decreasing the distribution cost per cubic meter from $5.80 to$5.40 by reducing distribution labor and warehouse rental costs.

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3. Process Decisions

Creating a map of the cost of important activities (activity cost pools) and the factors that cause these costs to be incurred (cost drivers and cost-allocation bases) opens many opportunities for improving efficiency. Management can evaluate whether particular activities can be reduced or eliminated by improving process.

4. Design decisions:

Management can identify and evaluate new designs to improve performance by evaluating the product and process designs impact activities and costs.

5. Planning and managing activities.

As was the case with Plastim, most companies implementing ABC systems for the first time analyze actual costs to identify activity-cost pools and activity cost rates. Many companies then use ABC systems for planning and managing activities.

Reference:

Activity-Based Costing and Activity based Management

Cost Accounting (A managerial emphasis) by Charles T. Horngren, George Foster, Srikant M, Datar and Howard D.Teall

Documents

Costing System at Plastim Corporation