Question

Question: Midwest Paper produces cardboard boxes. The boxes require designing, cutting, and printing. (The boxes are shipped flat, and customers fold them as necessary.) Midwest has a reputation for providing high quality products and excellent service to customers, who are major U.S. manufacturers. Costs are assigned to products based on the number of machine hours required to produce them. Three years ago, a new marketing executive was hired. She suggested the company offer custom design and manufacturing services to small specialty manufacturers. These customers required boxes for their products and were eager to have Midwest as a supplier. Within one year, Midwest found that it was so busy with orders from small customers, it had trouble supplying boxes to all its customers on a timely basis. Large, long-time customers began to complain about slow service, and several took their business elsewhere. Within another 18 months, Midwest was in financial distress with a backlog of orders to be filled.

Required

1. What do you believe are the major costs of making boxes? How are those costs related to the volume of boxes produced?

2. How did Midwest’s new customers differ from its previous customers?

3. Would the unit cost to produce a box for new customers be different from the unit cost to produce a box for its previous customers? Explain.

4. Could Midwest’s fate have been different if it had used ABC for determining the cost of its boxes?

5. What information would have been available with ABC that might have been overlooked using a traditional volume-based costing method?

Short answer

The company is facing the issue because of the wrong pricing decision based on the traditional costing method. The situation could have been handled well if ABC costing would have been used instead.

Step-by-step solution

Cost of box making

The major cost to produce boxes is material and overhead charges. As readymade boxes are delivered to customers, material cost is the prime cost for the product. After the material cost, overhead charges relating to designing, cutting, and printing are the major ones to produce boxes.

Material cost is directly related to the number of boxes produced. Cutting and printing are also dependent upon the number of units. Designing cost may be related to the designing hours, which is indirectly related to the number of units produces.

Difference between new and previous customers

The company’s old customers used to purchase the predefined readymade boxes. The boxes used to be uniform in terms of size and shape and design.

But the new customers are the ones that require customized boxes as per their needs. They demand boxes in particular sizes, shapes, and designs.

Unit cost of box

No, the unit cost to produce a new box for new customers would not be different from the previous production. The reason for this is that the company is using a single plant-wide rate system based on machine hours. So if the machine hour and total overhead were unchanged under both scenarios the per-unit cost would also be the same.

Cost of boxes under ABC

Yes, if the company had used the ABC system then distinct boxes would have been cost differently and the prices would also be charged differently. In such a situation, the company may find it helpful to handle the demand and supply.

Traditional method

The ABC system would have provided the cost relating to different activity and their drivers for making accurate allotments. This information is generally overlooked when using the traditional volume based costing method.