PAPPA Manufacturing Inc.

PAPPA Manufacturing Inc., manufactures and sells large business equipment

for the office and business markets. The primary function of Manufacturing is
to provide components and subassemblies for the profit centers within the
company. To maintain competitiveness, each profit center can purchase parts
either form Manufacturing or from outside firms. Manufacturing operates as a
cost center and charges the profit centers for the full cost of the parts. Costs
are computed once a year using full absorption costing. The volume of parts
used to calculate costs is provided by the profit centers to Manufacturing in
August; the fiscal year begin in January. With these numbers, Manufacturing
projects costs per part for the year. These cost estimates are then used
throughout the year to charge the profit centers. Any over/underabsorbed
overhead goes directly to the bottom line of the company, not to any of the
profit centers.
Within PAPPA Manufacturing, there is a department called finishing. The
finishing department provides a service to other Manufacturing departments
and profit centers as well as generating some external sales. Types of
finishing include painting and plating. The facility has large investments in
fixed asets in both automation and environmental compliance for finishing.
The finishing operation believes it provides a value to customers through its
high quality and its close location to the manufacturing departments.
During the past year, the profit centers have begun taking work away from
Manufacturing and giving it to outside vendors with lower quoted costs.
Manufacturing then has lower volumes and has to raise the prices on the
products it is producing, causing the profit centers to send even more work
out. Manufacturing feels it is caught in a death spiral.
The death spiral situation has affected finishing the most. The finishing
department is currently operating at 30 percent of capacity and has facilities
that are too large for the low volume of work. Table 1 summarizes the data
pertaining to finishing. Fixed costs make up 71 percent of the current cost
structure. Other manufacturing departments are beginning to tell finishing
that they will be sending their work out to get plating and painting so as not
to lose any work because of the high internal cost of finishing.
Finishing is trying to attract business from outside PAPPA Manufacturing. The
external sales guideliner require a 35 percent profit margin applied to the full

cost for all external work. With the current low level of work and high fixed
cost, finishing cannot attract external sales due to cost.
In an effort to gain control of the true cost drivers of the business, the
manager of the finishing operation has implemented activity-based costing.
Tables 2 and 3 project the cost for products and volumes for one plating
operation. The problem that the finishing manager now faces is that the
manufacturing departments are about to send the 12-inch and 18-inch work
to an outside shop due to lower costs.
In implementing ABC, the manager thinks he has truly identified the proper
system. The larger parts tend to run in smaller lot sizes and generate more
paperwork. Smaller parts tend to be run in larger lot sizes and generate less
paperwork.
In a recent meeting with the management of the manufacturing department
and profit centers, it was stated that the installation of ABC is in direct
conflict with the change in the mix of work from small part to large parts and
the need to run smaller lot sizes. The manufacturing department and profit
centers would like to pursue just in time manufacturing and further reduce
the lot sizes for both small and large parts. During this meeting, the profit
centers and manufacturing departments said the impplementation of ABC
would force them to move their work out of the finishing department to
outside shops.
Table 1 Finishing Annual Cost Structure
Annual Cost
Fixed
asset
$400,000 $4,000,000 machine purchased 2
depreciation
years ago
Tank operation costs
250,000 Cost to operate tanks-fixed cost,
not volume dependent
Tank material cost
50,000 Cost
to
operate
tanks$0.0007575/inch
Variable labor cost
210,000
$910,000

Table 2 Finishing Costs before and after Activity-Based Costing

Volume of
Pieces per
Old Cost per
ABC per
Outside Cost
Year*
Piece
Piece
per Piece

3 parts
1,000,000
$0.50
6 parts
200,000
1.00
12 parts
50,000
1.20
18 parts
100,000
1.50
*this volume of work uses only 30% of capacity

Table 3 Forecasted Costs

Old Cost
3 parts
6 parts
12 parts
18 parts
Total per year

$500,000
200,000
60,000
150,000
$910,000

$0.31
1.00
2.00
3.00

Activity-Based
Cost
$310,000
200,000
100,000
300,000
$910,000

$0.30
1.10
0.90
1.20

Outside Cost
$300,000
220,000
45,000
120,000
$685,000

Required:
Based on the current situation, what should you do, as a management
accountant, to help the manager solve that problem? Please make a
comprehensive analysis based on qualitative and quantitative aspects.
Explore your knowledge in management accounting tools that you learned in
the class.
Solution:
This case study ilustrates that poorly designed ABC system trying to
recover the cost of excess capacity can fail.
A. The problem is they are trying to recover a sunk cost fixed asset
depreciation of $400,000. Because volumes have fallen, the original
decision to acquire this much capacity turns out to have been wrong.
They should take a one-time charge profits by writing off some or most of
the $400,000 machine. This will then lower unit cost. Other issues include:
I.

The volume-related death spiral. When volume decreases you raise

prices, volume decreases more, you raise price more, etc.

II.

Is the accounting system broken? They are installing ABC to fix a

broken accounting system but that is not the major problem.
Allocating the historical cost of excess capacity is the problem.

III.

Unitized transfer price. Unitiaztion of fixed costs provides the wrong

decision information to management for short-run decision making
such as pricing special orders. Beware of unitized cost.

IV.

Both the old absorption and new ABC accounting systems are
sending the wrong signal for short run decisions. Both system are
signaling higher cost and thus the apparent necessity to raise price.
Given the high fixed cost and decreasing volumes, this is an
incorect inference.

V.

Allocating of decison rights (decision management versus decision

control). How should management change the allocation and what
will systems change do to the focus of managment? Are the benefit
of the imperfect decentralized system outweighing the cost?

B. In reviewing the data provided in table 2, the apperent cost drives have
been identified and properly allocated to the parts using ABC costing.
What is not apparent is that the unitized cost are misleading in the first
place. Unitized the fixed cost will cause the apparent profitability of parts
to vary with volume. This unitization is misleading and should be avoided.
Since the firm has so much excess capacity, the opportunity cost of this
capacity is close to zero. Thus, none of the depreciation on the plant
should
be
charged
to
products.
the details of the cost drives are not provided, although one can see
shifts in parts costs of up to 100 percent. The question to be asked is what
effect the changes in cost will have on the workload and whether the
costs of these drives should be reduced. If no action or effort is placed on
using the data obtained from the ABC system to reduce the cost of the
elementss, then why incur the expense of implementing ABC? The cost
and benefits of the system need to be evaluated.
C. If management is gaining a better understanding of the cost drives of the
business and implementing cost reduction activities, and the reductions
outwigh the cost of ABC, then they have not made a mistake.
they have made a mistake in the implementing process. The ABC
costing system is aimed at decision managment. However, the finishing
departement did not understand the implications of the signals that ABC
cost send to the rest of the firm (decision control) for short-run decisions.
If the departement management operated the ABC system in paralel to
the old system then they could have the information required to reduce
costs and not send the misleading signals within the firm.