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Ace Fertilizer Company: Ethical Cost Allocations and Price Determination Introduction Having a double undergraduate major in Accounting and...

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Ace Fertilizer Company: Ethical Cost Allocations and Price Determination Introduction Having a double undergraduate major in Accounting and Integrated Supply Management and an MBA from a renowned business school qualified Abby Conroy, CMA, for her position at Ace Fertilizer Company. She has been employed at Ace Fertilizer for the past three years, and is a highly respected employee. Her hard work and dedication to detail resulted in a series of rapid promotions. Currently, Abby is assistant director of manufacturing and is primarily responsible for special customer orders. Meeting the needs of customers in manufacturing special orders has become a very profitable portion of Ace’s operations. These special orders sometimes complement, but more frequently are totally unrelated to, Ace’s principal business of producing lawn and garden fertilizer. Ace Fertilizer actively seeks special orders in a highly competitive market, driven more by quality and on-time completion than price. Ace has established itself as an industry leader by consistently meeting customer expectations. The ability to meet the needs of customers through manufacturing special orders was the concept of Ace’s founders, and now passive owners, James Stegink and Norman Light. Both have engineering degrees and are considered by many to be quite the “tinkerers.” Abby reports to the director of manufacturing, George Smilee. The manufacturing operations are managed by Tom Brennen, the chief operating officer of Ace Fertilizer. In her role as assistant director, Abby is responsible for the design, bidding, manufacture, and ultimate delivery of special orders to customers. Abby develops and completes all special order contracts. George Smilee initials his approval of these contracts. Completed, initialed customer contracts then proceed to Tom Brennen for his ultimate approval and signature. All special orders at Ace Fertilizer follow a prescribed billing formula. These special orders, unless specific authorization is obtained from Tom Brennen himself, must be billed at 80 percent over the cost of the order. Tom Brennen rarely allows exceptions to this formula, as sufficient demand exists for Ace Fertilizer’s operating capacity. Although Ace maintains an extensive raw materials inventory, on occasion these special orders require Abby to order materials specific to the order. These materials are acquired in the most economical order quantity available. The special order is billed for the entire cost of the specially ordered materials, even if unused quantities remain. Customers are given the option of keeping these unused materials, but virtually all companies decline. An exception to that policy is only allowed when another confirmed order exists when the initial order is signed that requires the use of those excess materials. In that case, Tom Brennen, as a matter of fairness, insists that the cost of those materials be prorated among special orders. What Abby likes especially about Ace Fertilizer is its family atmosphere. In fact, Abby has been invited several times by George Smilee to his family get-togethers. George is close to his family, most of whom live within a 10-mile radius. The family has regular get-togethers attended faithfully by George and his two brothers. George’s family has become very close since the
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untimely death of George’s father last year. His brothers are all self-employed in a variety of businesses, and on occasion Ace Fertilizer does special orders for them. Abby has become very skilled at computing the cost of special orders. She fully realizes a special order includes a variety of costs, including direct and indirect costs. Abby knows that proper project cost determination mandates inclusion of all of these costs. Direct Costs vs. Indirect Costs Direct costs are those costs that are easily and conveniently assigned to a special order. Major direct costs for Abby are direct materials and direct labor. Direct materials are those materials that become an integral part of the finished product. Direct labor, sometimes referred to as “touch labor,” includes the cost of those laborers who directly touch the product while it is being made. The wages of general production employees who are idled due to machine breakdown are classified as indirect costs. Direct costs are usually variable and change as production volumes change. Thus, direct materials and direct labor are typically variable costs. For special orders, some direct costs can be fixed, however. The costs (depreciation, electricity, and routine maintenance) associated with a machine dedicated to one product are direct costs of that product. Indirect costs cannot be easily and conveniently assigned to a special order. Rather, these costs are common costs, in that they are incurred to produce a variety of special orders. Maintenance costs of general purpose equipment, the supervisor’s salary, and utilities are direct costs needed to produce special orders in general, but are indirect costs for a particular special order. Moreover, general production costs, including property taxes, insurance, lawn care, cafeteria costs, and miscellaneous supplies consumed in production are indirect costs properly allocated to special orders manufactured. Allocation of Indirect Costs Abby could allocate indirect costs to special orders using a company-wide overhead rate. Frequently, these indirect costs are allocated by selecting an allocation base common to all of the company’s products or services. Many companies base overhead allocations on direct labor-hours or machine-hours. Abby realizes, however, that this allocation process is troublesome as it is impractical to trace these costs to specific orders. Alternatively, Abby could allocate indirect costs to special orders using activity-based costing (ABC). Rather than simply allocating indirect costs among special orders using a company-wide rate, ABC acknowledges that not all costs are driven by output volume. As a result, information is available to help determine the most profitable special orders and customers, which activities and processes are value-added, and where efforts toward improvements can be made. Abby especially likes this latter approach when assigning indirect costs to special orders.
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