Arctic Insulation

This case is set in 1980 in a waste paper converting plant in New York City in a company whose business is tied closely to environmental recycling trends. The sub ect is product costing and cost contro!" Arctic Insulation manufactures material used in home insulation. The company mixes scrap paper and fiber to form the insulation material that is bagged, sold and finally blown into home attics. The company has two methods of obtaining scrap paper. They can buy from the public at nominal rates (through paper drives and individual deliveries to the loading dock) or purchase bulk paper from scrap paper dealers. It is cheaper to buy from the public, but additional labor time is involved in removing the paper, in relatively small amounts, from customer cars and trucks at the loading dock and forming the paper into bales. irect labor is very expensive with rates at !"#,$$$ per worker per year (!#.%$ per hour) in "#&#. In "#&#,' "(' bales weighing )$$ pounds each were formed per hour by each employee, on average. The process of forming bales is very time consuming because paper must be sorted by type (coated, newsprint, or fine paper), and by color (white, colored), must have any metal removed (staples or grommets), and must be cut to standard si*es. Also, after the bale is formed, it is bound with wire in a baling machine so that it can be stored pending further use. +n the other hand, scrap paper can be purchased from paper dealers already sorted and cleaned and cut to standard si*es. The purchased paper is more expensive, but much less labor time is involved because the workers are only re,uired to unload the paper from a truck and bale it. In "#&#, "- .purchased. bales weighing )$$ pounds each were handled per hour by each employee, on average. /rices in the scrap paper industry are very volatile. 0upply and demand factors in large industries regularly cause wide fluctuations in the price per pound for scrap paper. 1henever the price in the scrap paper market drops markedly Arctic cuts the price it offers to the public, thereby reducing the amount supplied, and increases the purchase of bulk paper from dealers. Aggressive scrap paper companies utili*e these swings in market price to stock up during price declines for sales in future periods. Arctic Insulation operates '' collection and baling depots throughout the 2ew 3ork metropolitan area. 4ach depot is open '5 hours a day, & days a week. These depots feed raw materials into 5 shredding and bagging plants. Arctic is one of two divisions of 6ecycling 0pecialists, Inc.7 the other division is 0crap Iron and 8etal, Inc. In 8arch, "#9", the president of 6ecycling 0pecialists was reviewing financial reports for the year ended ecember )", "#9$ in comparison with "#&#. 1hen he came to the report shown in Table " he noted that unit processing costs and also bale volume were increasing.

)9

Arctic Insulation

TA:;4 "

All epots <ombined 0ummary <ost 6eport

!
=ormed :ales> irect ;abor epot +verhead ivision +verhead Total Increase ? "#9$ vs, "#&# /urchased :ales> irect ;abor epot +verhead ivision +verhead Total Increase. "#9$ vs. "#&# !5,"'9,$$$ ',&-%,&-$ ),)95,#-$ !l@,'"9,"'@

"#&# <ost /er :ale !).95 '.%& )."% !.'.,'@

"#9$
$

<ost /er :ale !).95 )."%

3042 $10041 $,.82

!),$5",'9$ ',5#),9%$ ',&$-,&5$ !9,'5",9&$

!"-9,$$$ ""',%-$ ")&,&-$ !5"9.)'$

$.60

.5# !;5'

AO

!%"5,9$$ 5'',"5$ 5%9,"-$ !",)#%,"$$

!.-$ .5# .%) !".-'

$JJ

Ae was concerned about the cost control aspects of the increase in per unit costs so he invited the general manager and the cost accountant for the division to his office for a meeting. In preparation for the meeting, the cost accountant made photocopies of the 0upplementary <ost 6eport (see 4xhibit "). After studying the 0ummary <ost 6eport and the 0upplementary <ost 6eport (Table " and 4xhibit "), the division general manager was having a difficult time accepting the contention that unit costs had increased. Ae finally put together his own cost calculations showing that depot costs per unit had in fact declined between "#&# and "#9$ (see 4xhibit '). Ae made photocopies of his calculations to distribute at the meeting. In "#9$, the mix of purchased bales and formed bales changed considerably. :ecause of a steep decline in the price of bulk scrap paper, the use of purchased bales increased. =ormed bales dropped from &9B to 59B of total bales processed. In addition, the total number of bales handled increased approximately ''B. 4ven though total volume increased, labor costs actually declined in "#9$ because of the smaller number of formed bales handled. <osts charged to the collection and baling depots are of three types> first, direct labor (sorting and baling) in the depot7 second, overhead charged directly to the depot7 and third, an allocated share of general division overhead. <ost of purchased paper is not charged to the depots, but rather is collected at division level and assigned to products at the shredding and bagging plants. The cost

accounting department allocates the overhead incurred directly by each depot to the two products processed (formed bales and purchased bales) within a depot based on the dollars of direct labor for each product. The overhead rate for depot overhead is determined by dividing the total depot overhead by total depot direct labor. The division overhead is allocated to depots based on direct labor dollars. The division overhead rate is e,ual to the ratio of total division overhead to total direct labor in the entire division, including the four shredding and bagging plants as well as the twenty two collection and baling depots. The items included in depot overhead are shown in 4xhibit 1. The largest item is indirect labor, including salaries for '' foremen (each foreman is in charge of a depot and was paid !'',5$$ in "#&#) and wages of the forklift drivers who deliver bales from the baler to the storage area. These drivers also support the baling operation by refilling the spools of baling wire as they became empty. In "#&#, each driver handled & ""'bales per hour, on average. The drivers were paid !"%,$$$ each (!&.%$ per hour) in "#&#. epot overhead also includes repairs, supplies, power, -B 0ocial 0ecurity Taxes (=I<A), depreciation, insurance and office expenses. ivision overhead includes division?wide miscellaneous labor, building repair labor and material, manufacturing administrative salaries and other general costs associated with purchasing, accounting and administration. uring the meeting, the cost accountant told the president that in "#9$, the depot overhead rate had

Arctic Insulation

)#

increased from -&B to 9'B of direct labor and that the increase in unit cost per bale was, as shown in Table ", largely attributable to this increase. Another factor, he said, was a -B increase in all wages and salaries between "#&# and "#9$. The division manager said that he was certainly not a trained accountant, but that from a common sense point of view it would be very difficult to convince him that cost per unit was increasing. when in fact total costs were decreasing and total output was increasing. Ae said the problem had to be in the overhead allocation scheme. Ae said that under the current allocation scheme based on direct labor dol"ars the formed bales are charged more than a fair share of the overhead. =or a correct unit cost determination, he felt that overhead should be allocated on a per bale basis, not as a percentage of direct labor dollars. Ae gave the president and the cost accountant copies of his schedule (4xhibit ') in defense of his argument. The unit costs per bale for formed and purchased bales are used in determining standard costs for the finished product, the bags of insulation. These standard costs, however, are used only sparingly because of the rapidly changing cost conditions in the industry. The company uses standard costs for finished products only as a general guide in measuring the profitability of the bags of insulation sold. /ricing is usually set by competition, but there is some flexibility in product emphasis, particularly over the longer run. 1hen demand for paper and insulation is high, the division operates at capacity . . In "#9$, operations were at about 9$B of capacity.

QUESTIONS 1. Are unit costs per bale rising or falling between "#&# and "#9$C 0upport your answer with the relevant cost calculations. 1hat inferences do you draw regarding the. cost control issue which is of concern to the presidentC Aow well were costs controlled in "#9$C 1hat recommendations would you make regarding the 0ununary <ost 6eports for the collection and baling depotsC 1hat other advice do you have for the presidentC 0uppose bulk scrap paper from scrap paper dealers is selling for !.$"% per pound more than the price being offered at the loading dock for casual paper. 0hould management be emphasi*ing bulk purchases or casual purchasesC

'.

).

4. 5.

."#$!i%

5$

Arctic Insulation
,:':';::

4DAI:IT

"

All epots <ombined

0upplementary <ost 6eport ecember )","#&# and "#9$ "#&# irect ;abor epot +verhead Indirect ;abor 6epair ;abor 6epair 8aterials 0upplies /ower +ther (including =I<A tax) Total Allocated ivision +verhead Total = onned :ales /rocessed /urchased :ales /rocessed Total !5,'#-,$$$ "#9$ !),%%-,$9$

",9&%,$$$ "$",$$$ )-,$$$ %),$$$ %%,$$$ &%9,)'$ ',9&9,)'$ ),%'',&'$ !,;@..-.'",$5$ ",$&%,$$$ '9$,$$$ "..)%'."$$$ (&#.)B) ('$,&B) ("$$.$B)

',$"#,$$$ #&,$$$ 5),$$$ 5-,$$$ %#,$$$ -%",##$ ',#"%,##$ ),"-5,#$$ !.',,-)-,#&$ &#',$$$ 9%9,$$$ ",-%$,$E@@ (59B) (%'B) ("$$B)

'

.. >

Alternative :y the

4DAI:IT ' epot <ost 6eport as /roposed ivision Feneral 8anager "#&#

! =ormed :ales> irect ;abor epot +verhead Allocated ivision +verhead Total ecrease ? "#9$ vs. "#&# /urchased :ales> irect ;abor epot +verhead ivision +verhead Total ecrease ? "#9$ vs. "#&#

<ost /er :ale

s
!),$5",'9$ ",)##,-&% ",%"#,"%$ !%,#-$,"$%

"#9$ <ost /er :ale

!5,"'9,$$$ ','9),%5$ ',&#5,&9$ !','$-,)'@

!).95 '."' ',-$ !9.%-

!),95 ".&& ".#' !&.%) !".$)

!"-9,$$$ %#5,&9$ &'&,#5$ !",5'@,"'$

!.-$ '."' '.-$ !%,)'

!%"5,9$$ ",%"-,)"% 1&'()&*)0 !),-&-,9-%

!.-$ ".&& ".#' !5.'# !",$)