TO: Professor and Manager FROM: SUBJECT: Forrest Hill Evaluation of Profits and Costing Systems DATE: November 1, 2013 Executive Summary Throughout this report, our team will describe how we used activity based costing to allocate costs, illustrate why the traditional system is faulty, and recommend changes that Forest Hill Paper Company should consider implementing in the near future. After closely reviewing the financial and production data, our accounting team has found that your traditional cost allocation is faulty and misleading.
The costs of products A and C were over allocated and products B and D were under allocated ausing deceptive information on the true profits of the company. Also, product B appears to be making a profit, however, it is losing $2307 per reel. As suggested, the assets of Forest Hill Paper Company have not been used to the greatest advantage. For instance, the most lucrative product was found to be D with a profit of $5,299 per reel; whereas the least profitable product was B with a loss of $2,307 per reel.
It was also found that slitting costs were being allocated to all of the products when in reality, slitting should only be allocated to products A and C. This is important ecause slitting contributes an estimated $2,300 of costs per reel; a cost that should not be assigned to products B and D. Our team has reviewed several alternatives for Forest Hill to consider to generate a higher profit margin. For instance, it may be effective to discontinue the slitting service if it wouldn’t drastically affect your current customer base.
Additionally, the FHPC accountants should become more familiar with ABC costing system to have a better understanding of the company’s cost allocations and profits. Analysis of Costing After analyzing the company’s costing procedures, the traditional costing system has very different outcome for the profit as opposed to the activity based costing system. To get the profit for traditional costing, we took the overhead rate of 105% and multiplied it by the materials cost. We then subtracted this and the materials cost from the sales price to get the profits shown in the table below.
Traditional Costing Product Average Reels per Batch Price Materials Cost per Reel Contribution Margin Overhead Cost per Reel Profit (Loss) 50 $12,600 $4,800 $7,800 $5,040 $2,760 2 $13,500 $5,200 $8,300 $5,460 $2,840 c 35 $14,200 $5,600 $8,600 $5,880 $3,000 175 $19,500 7,400 $12,100 $7,770 $4330 To calculate the new volume based overhead rate after removing grade change and slitting costs, we took each product’s number of reals and multiplied it by material cost per real. Then we divided that number by the total cost of producing all four products.
We calculated the new volume based overhead rate to be 91 percent. Next, we calculated the cost of grade change per reel for each product. To do this, we took the total grade change and divided it by the number of products, four, and divided that number by the average reals per batch for each product. Then, we better allocated the cost of slitting. To do this, we took the products that are slit, A and C, and took the total cost for slitting and divided it by 85, the average reels per batch for products A and C.
The profit of each reel in the ABC costing system is shown below. c costlng $6897 $903 $10,607 $7,726 $874 $6,801 $5,299 The traditional costing system that was in place was ineffective and inaccurate. This costing system over allocated costs to A and C, and under allocated costs to product B and D. Consequently, this information gave a false impression that product D was less profitable than it actually is, and that A, B, and C were more profitable than they are. These findings are demonstrated in the bar graph below.
Recommenaatlons As consultants to Forest Hill Paper Company, we recommend that the company consider the following actions to potentially increase profits and effectively allocate costs. Firstly, it is strategically beneficial for the company to continue to produce products A, C, and D. However, you should discontinue production of product B, as it is unprofitable and is losing the company money. Product B has been losing the company $2,307 per reel. If the company deems it is essential to keep producing product B in order to retain their customer base, we recommend changing the production schedule.
For example, during times of lower demand, you can produce products such as B that do not make as much money, but you will still retain your customers’ business and satisfy their needs. During times of higher demand, by discontinuing the production of product B, the company will be able to produce the more profitable products such as A, C, and D. Another way to change your profit if you deem product B essential to your company, is by producing more consecutive atches. The cost of doing a grade change for product B is currently $5,875 per reel.
If you were to do two batches of product B in a row without doing a grade change, the cost of grade change would drop to $2,938 per reel, and a profit of $625 per reel. After either discontinuing or raising the price of product B, we would recommend running a year long trial period to closely monitoring the profits of each product. If Forest Hill is still losing money, we recommend the company eliminate slitting of products A and C. If you were to drop the slitting costs, products A and C would make pproximately $2,300 more in profit per reel.
However, we understand that dropping slitting could reduce your competitive advantage and drop your customer base. If slitting is deemed essential, we recommend that you require customers to buy enough of product’s A and C that the costs of slitting are spread out enough that you are making more profit. We also recommend that the company should start the process of converting to an activity based costing system from the formerly used volume based costing system. To do this, the company needs to better allocate their costs to each product as shown in the graphs above.
For example, slitting costs need to be assigned to products that use the slitting machine only. In addition, the company should carefully review the pricing strategy for each product if dropping product B is not an option. You could raise the price of product B to compensate for the loss. These are the recommendations that we have come up with after viewing your financial records. We understand that there are other managerial factors to take Into account; nowever, we strongly suggest tnat you cons10er our recommenaatlons. We feel that these recommendations can substantially increase your company’s profits.