Product Costing

at Fine Foods By INSPIRATION

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ContentsContents

Case overviewCost allocationSpecial orderEvaluationConclusion

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Case OverviewCase OverviewGreat Plain Capital

(Share Holder)

Fine Food, Inc Fine Food Canada,

ltd

Other Co. are not located in

USA and CAD

SMU1 SMU3SMU2

Supermarket

1 Institutional customers2 Special order3 Mp outperforms 1,3 in terms of sales.

Export to other countries, governmental organizations

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Issue III

Summary Issue I

Issue II

Cost AllocationCost Allocation

CostAllocation

CostAllocation

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•All costs for steam boilers, building maintenance, vehicles, and sanitation are allocated directly to products using net or gross weight.

SummarySummary

•Sales and marketing costs, which are incurred only in SMU1 and SMU2, are allocated to products based on sales volume.

•Costs for top management, business administration, information systems, human resources, supply management, and logistics are allocated in two steps.

•Costs are first allocated to cost centers based on number of employees, labor time, production time, or set percentages. Then costs are further allocated to products base on gross sales, amount of time spent on internal reviews.

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Issue IIssue I

The time and procedure of products for all costs of steam boilers, building maintenance, vehicles, and sanitation are different.

Those products which are heavier, less time consuming and easier to manufacture should be allocated with more costs.

allocate net and gross weight to products directly was unfair

Treat every product in a detailed manner. The distribution ratio can be determined by the procedure, machine hours and frequency.

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Product X——Requires simple processing

Product Y——Requires processing and package

Issue I - ExampleIssue I - Example

Product Z——Requires complex processing and package

The processing and package are different among products.It’s unreasonable for Product X if various kinds of costs are allocated simply by weight.

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Issue IIIssue II• The allocation of Sales and marketing costs, which are incurred only in

SMU1 and SMU2 ， based on sales volume was unfair.

Reasons and Analysis

SMU1 and SMU2 are allocated to products based on sales volume, which is improper

The elasticity of SMU1 is larger than that of SMU2 in sales and marketing costs

Each dollar spent on SMU1 makes more profit than that of SMU2, but two department shares the same sales volume cost.

SMU1 and SMU2 have their independent sales department. So the actual cost should be calculated by revenue earned respectively.

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SMU1

Sales volume is

Y1

X Dollars was spent by the Co. on Sales and marketing

costs.

SMU2

Sales volume is Y2

Issue II - ExampleIssue II - Example

SMU2 serves institutional customers and sells special orders.The elasticity of SMU2 of marketing is less than that of SMU1.

IF the company

increase 1000 Dollars in Sales and Marketing

SMU1

Actual sales increase by 2

0%

SMU2

Actual sales increase by

1%

SMU1

Fees: Z1=1000*1.2Y1/(1.2Y1+1.01Y2)Profit: R1=0.2Y1*Price Obviously ， R1/R2

(=20Y1/Y2) > Z1/Z2 (=120Y1/101Y2). Thus, such type of allocation

is unreasonable.SMU2

Fees : Z2=1000*1.01Y2/(1.2Y1+1.01Y2)Profit: R2=0.01Y2*Price

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Issue IIIIssue III

Issue

There is no uniform and detailed standard for the allocation of the costs of top management and business administration.

Reason and Analysis

In this issue, too many methods of allocation are introduced. Nevertheless, the final results of various ways of distribution are different, which will certainly lead to cost-sharing disputes between departments.

Solution

The administration expenses should be refined to a specific accounting system ---- activity-based allocation. The most reasonable allocation of the costs should be used depending on the attribute of the activities.

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Summary Issue1 Issue2Special Order

Summary

•A special order is one in which the contract specifies that it can be rejected within one year before delivery; otherwise it isn’t special. Such special orders constitute 2% of total revenues for Fine Foods.

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Summary Issue 1 Issue2Special Order

● Issue I ： The cost on Smu2 for MP is not in compliance with its revenue

Put Brand on its Products

To make full use of the existing cost ，Fine Food should lay more emphasis on this Market.

Enlarge the Specifications

Fine Food should provide more product specifications and enlarge the customer groups.

To make customers easy to purchase.

Improve the Channel

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Summary Issue1 Issue2Special Order

● Issue II ： The Co. share the revenue from SMU2 ， but it didn’t compensate its loss on producing Special Order.

Original MethodCM1=Net sales-Variable manufacturing cost-Freight

Suggested MethodCM1=Net sales-Variable manufacturing cost-Freight-Storage cost

Costs of administration was neglected

Warehouse management fees was neglected

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Operating Profit

Operating profit ， also called EBIT (earnings before interest and tax), is a measure of a company's earning power from ongoing operations, equal to earnings before deduction of interest payments and income taxes.

Operating profit ， also called EBIT (earnings before interest and tax), is a measure of a company's earning power from ongoing operations, equal to earnings before deduction of interest payments and income taxes.

EvaluationEvaluation

Evaluation Principle

1. Be objective, scientific and fair2. Be comprehensive and comparative3. Combine quantitative with qualitative analysis4. Combine technological with economic analysis5. Combine micro with macro efficiency analysis

1. Be objective, scientific and fair2. Be comprehensive and comparative3. Combine quantitative with qualitative analysis4. Combine technological with economic analysis5. Combine micro with macro efficiency analysis

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Whether adopting the operating profit as the primary indicator for evaluation is fair and reasonable to SMU2?

Whether adopting the operating profit as the primary indicator for evaluation is fair and reasonable to SMU2?

Issue IIssue I

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Operating profit = Contribution Margin 4 - Structure Cost - Overall Depreciation

Formula Formula

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AnalysisAnalysis•1)The structural costs and total depreciation will not be increased due to the increase of a certain type of product.

•2)since product MP is relatively dense, bulky and heavy, it carries an unreasonable heavy burden, namely, more costs was allocated to it.

For Example

CM4=20,000$ Structural Costs + Total Depreciation=25,000$ Operating Profit=-500$

What is more, such a phenomenon is not only an exaggerate hypnosis. Because, when deciding to accept the special order, SMU2’s power of decision lies only on whether CM1 is positive or not while not on method of perform-ance evaluation and cost allocation. 

SMU2 bring positive revenues to the CO. by producing more product MP because CM is positive. However, from the perspective of the performance evaluation, SMU2 has only done a poor job because the operation profit is negative.

CM4 of product MP is positive? It is smaller than structural costs plus total depreciation?

Even if the operation profit for SMU2 is positive, such an evaluation method can't reflect its real performance.

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What’s more, such an evaluation will lead to agency costs issues. Since the positive contribution made by SMU2 can’t lead to the positive evaluation, the working enthusiasm of SMU2’s staffs were affected, which will bring negative influence to the Co.’s whole welfare.

Agency Cost

Issue IIIssue II

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Using the operation profit as the primary

indicator for performance evaluation

is unfair and unreasonable to SMU2.

The Fine food Company should instead consider other evaluation methods such as

contribution margin and return of investment to

evaluate SMU2 so as to reveal the true situation of SMU2 and

to offer a fair performance evaluation.

Suggested Solution

Conclusion

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Outline Outline

CaseOverview Conclusion

Cost Allocation Cost Allocation

Special Order Special Order

EvaluationEvaluationEvaluation

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Allocate net and gross weight to products directly was unfair. 1

There is no uniform and detailed standard for the allocation of the costs of top management and business administration. 3

The cost on Smu2 for MP is not in compliance with its revenue.4

The allocation of sales and marketing costs, which are incurred only in SMU1 and SMU2 to products based on sales volume was unfair.

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Using the operation profit as the primary indicator for performance evaluation is unfair and unreasonable to SMU2, and the strategic mistake might occur.

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Conclusion Conclusion

The Co. share the revenue from SMU2 ， but it didn’t compensate its loss on producing Special Order.5

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By INSPIRATION