I M A EDUCATIONAL CASE JOURNAL1V OL. 2, N O. 3, ART. 3, SEPTEMBER 2009Abby has become very skilled at computing the cost ofspecial orders. She fully realizes a special order includes avariety of costs, including direct and indirect costs. Abbyknows that proper project cost determination mandatesinclusion of all of these costs.to help determine the most profitable special orders andcustomers, which activities and processes are value-added,and where efforts toward improvements can be made. Abbyespecially likes this latter approach when assigning indirectcosts to special orders.DIRECT COSTS vS. INDIRECT COSTSBREELAND LTD. SpECIAL ORDERDirect costs are those costs that are easily and convenientlyassigned to a special order. Major direct costs for Abbyare direct materials and direct labor. Direct materials arethose materials that become an integral part of the finishedproduct. Direct labor, sometimes referred to as “touchlabor,” includes the cost of those laborers who directlytouch the product while it is being made. The wages ofgeneral production employees who are idled due to machinebreakdown are classified as indirect costs.Direct costs are usually variable and change as productionvolumes change. Thus, direct materials and direct labor aretypically variable costs. For special orders, some direct costscan be fixed, however. The costs (depreciation, electricity, androutine maintenance) associated with a machine dedicated toone product are direct costs of that product.Indirect costs cannot be easily and conveniently assignedto a special order. Rather, these costs are common costs, inthat they are incurred to produce a variety of special orders.Maintenance costs of general purpose equipment, thesupervisor’s salary, and utilities are direct costs needed toproduce special orders in general, but are indirect costs for aparticular special order. Moreover, general production costs,including property taxes, insurance, lawn care, cafeteriacosts, and miscellaneous supplies consumed in productionare indirect costs properly allocated to special ordersmanufactured.The Cost Estimate. Abby has received a request from BreelandLtd. to produce a unique, somewhat unstable cleaning solventfor use in Breeland’s specialized steel plating process. AceFertilizer is one of only a handful of companies across thecountry capable of producing such a solvent. The customerhas a limited need for this solvent, and does not foreseerequiring quantities of it beyond this special order. To producethis substance, Abby must purchase a specialty acid ingredientknown as XO-1600. That substance is only available in50-gallon drums. The 50-gallon drum costs $80,000. Thisspecial order will only require the use of 40 gallons. XO-1600has a shelf life of only 20 days after the drum is opened. Afterthose 20 days, the substance becomes very unstable and mustbe discarded. Because of the chemical nature of the substance,it requires proper disposal. Abby estimates the cost of thisdisposal at $10,000. Abby has checked existing, confirmedorders and found none that will require XO-1600 within thenext 20 days. Inquiries with representatives at Breeland Ltd.reveal that they have no interest in taking possession of theunused gallons.Abby also determines that several other costs andactivities will be associated with the completion of thespecial order for the solvent. These costs and activities are:1. Direct materials, in addition to XO-1600: $20,000.2. Direct labor: $30,000.3. Unit measure of special order: 4,000 gallons.4. Number of batches for production: 4 (due to constraintsALLOCATION Of INDIRECT COSTSduring the mixing process).Abby could allocate indirect costs to special orders using acompany-wide overhead rate. Frequently, these indirect costsare allocated by selecting an allocation base common to all of thecompany’s products or services. Many companies base overheadallocations on direct labor-hours or machine-hours. Abby realizes,however, that this allocation process is troublesome as it isimpractical to trace these costs to specific orders.Alternatively, Abby could allocate indirect costs to specialorders using activity-based costing (ABC). Rather thansimply allocating indirect costs among special orders using acompany-wide rate, ABC acknowledges that not all costs aredriven by output volume. As a result, information is availableIM A ED U C ATIO NA L C A S E JOURNALUsing ABC at the beginning of the costing period, Abbyarrives at the following costs for each of the five activity measures:a. Unit-level activities: $40 per unit of measure.b. Batch-level activities: $5,000 per batch.c. Product-level activities: $80,000 per project.d. Customer-related activities: $30,000 per customer.e. Organization-sustaining activities: 100% of directmaterials, direct labor, unit-level activity costs, andbatch-level activity costs.2V OL. 2, N O. 3, ART. 3, SEPTEMBER 2009Toward the end of the day on Friday, Abby works upthe following cost estimate and price determination for thisspecial order:Josh briefly walks away from the group, calls his customer,and confirms the order. Smiling, Josh informs George of thenews. The two agree to finalize this arrangement later inthe coming week.Josh’s Project Price Determination. Early Monday morning,Direct materials:Non-XO-1600George goes to Abby’s office to inform her of the developmentwith Josh over the weekend. He explains Josh’s intent topurchase the remaining 10 gallons of XO-1600. Georgeindicates that the details of that agreement are to be finalizedlater in the week. Pausing for a moment to fully understandthe details of this arrangement, Abby remembers and informsGeorge that the price quote last Friday assumed that the extra10 gallons would remain unused and would require disposal,and accordingly the order included the entire cost of the XO1600 plus the mandated disposal costs. Abby suggests thatBreeland Ltd. be informed of a slight delay in the price quoteand if Breeland agrees to the delay, then the initial order canbe revised in light of Josh’s forthcoming order.To Abby’s surprise, George is very cold to the idea ofdelaying the initial order. George contends that as of today,there are no confirmed orders that would require the extra10 gallons of XO-1600. In fact, there will be no confirmedorders until later this week, when Josh meets with Georgeto finalize the weekend arrangement. Consequently, Georgemaintains that the special order as presently priced shouldbe forwarded to Tom Brennen for his approval and signature,and if and when a formal order is received from Josh, thatorder should simply include a prorated cost for the 10 gallonsof XO-1600 plus a profit markup on cost. George, in fact, iselated and sees this as a windfall, as the 10 gallons of XO1600 can be billed twice and the billed disposal costs wouldnot be incurred. This pleasant turn of events adds $93,600($16,000 for the 10 gallons of XO-1600, $10,000 of eliminateddisposal costs, $26,000 for organization-sustaining levelactivity costs, and $41,600 for markup on the cost of the 10gallons of XO-1600) to the company’s bottom line.Abby fully realizes that she had already developed theprice quote for Breeland’s order the week before, and GeorgeSmilee had expressed his approval. Since there were noconfirmed orders existing at that time for the unused portionof the XO-1600, Abby, according to company policy, includedthe entire acquisition cost plus disposal costs in the costestimate. Abby now knows that an order in all likelihoodwill be obtained within the 20-day disposal period for theremaining 10 gallons of XO-1600. Given this new information,Abby believes that her original cost estimate should beamended pending approval of a delay by Breeland Ltd.$ 20,000XO-1600: Purchase cost80,000Disposal cost10,000Direct labor30,000Unit-level activity cost ($40 * 4,000 gallons)Batch-level activity cost ($5,000 * 4 batches)160,00020,000Product-level activity cost80,000Customer-level activity cost30,000Organization-sustaining level activity cost(20,000+80,000+10,000+30,000+160,000+20,000Total costs of Breeland Ltd. special orderMarkup
on cost ($750,000/.80)320,000$ 750,000900,000Total price Determination for Breeland Ltd. Order$1,650,000Abby discusses this estimate and price quote with GeorgeSmilee, who expresses preliminary approval. Abby fullybelieves that Breeland Ltd. will accept this price quote. Allthat is needed now is Tom Brennen’s formal approval andsignature. Before Abby and George leave for the weekend,they both concur that it is highly probable that Breeland’sspecial order will be approved next week. Details as toproduction and completion dates will be finalized uponapproval of the special order.The Weekend Family Get-Together. The Smilee clan has a get-together planned for Saturday afternoon, and George informsAbby that he is really looking forward to it. Unfortunately,Abby has prior plans and cannot attend.This is a very special occasion for George’s family, asGrandma Smilee has just turned 80 years old. The weatheris just perfect for the gathering. George mingles with hisfamily and is truly enjoying himself. After the meal andgames, George spends some quiet time with his brothers.He is sharing some of the details of the special order forthe solvent. When one of his brothers, Josh, hears Georgemention the chemical XO-1600, he becomes very interested.It turns out that he has recently been approached by acustomer to manufacture a spray-on rust inhibitor thatrequires XO-1600 as an ingredient. The quantity neededfor that order is 8 gallons, but Josh thinks he can convincethe customer to expand his order to use all of the 10 gallons.I M A ED U C ATIO NA L C A S E JOURNAL3V OL. 2, N O. 3, ART. 3, SEPTEMBER 2009Alternatively, Abby would like to submit a revised quoteto Breeland Ltd. if Josh’s order is finalized within 20 days.Specifically, she would like to only bill Breeland Ltd. for 40gallons of XO-1600, delete the disposal costs, and modifythe organization-sustaining and profit on cost amounts.Josh would then be shipped the product and be billed forthe cost of the 10 gallons of XO-1600. Contrary to George’ssuggestion, Abby believes that Josh should also be billed anappropriate organization-sustaining cost amount in additionto a profit on cost. Even these amounts, however, wouldresult in a smaller profit margin for the special order andwould not allow the company to meet its monthly profit goal.George Smilee seems adamant in his determination and hasinstructed Abby to develop a quote for Josh independentof the cost determination for the Breeland special order.George is meeting with Tom Brennen the first thing onWednesday morning to get his approval and signature on thespecial order. Abby is contemplating what course of actionshe should take. She plans to rely, in part, on the guidanceprovided by the Institute of Management Accounting (IMA)in its Statement of Ethical Professional Practice, found in Table1. Abby is wondering why George Smilee is not using thissame guidance. She wonders if George would be takinga similar position if he also were a Certified ManagementAccountant (CMA).ABOUT IMAWith a worldwide network of nearly 60,000 professionals,IMA is the world’s leading organization dedicated toempowering accounting and finance professionals to drivebusiness performance. IMA provides a dynamic forum forprofessionals to advance their careers through CertifiedManagement Accountant (CMA®) certification, research,professional education, networking and advocacy of thehighest ethical and professional standards. For moreinformation about IMA, please visit www.imanet.org.REqUIRED qUESTIONS1. Did Abby compute the cost of the Breeland Ltd. specialorder correctly before the weekend get-together? If not, howwas her cost estimate and/or price determination flawed?2. Whose assessment of the costing of this special orderdo you believe is correct—George Smilee’s or AbbyConroy’s? That is, should George’s conversations withJosh impact Abby’s cost estimate of the Breeland Ltd.special order? Explain your answer.3. Are there any ethical issues related to the cost determinationon the Breeland Ltd. special order? If so, what issuesare present? How should Abby resolve these conflicts?Should Abby go directly to Tom Brennen about this newdevelopment? How can Abby use the IMA Statement ofEthical Professional Practice as a guide for her actions?4. If Abby were to modify her original cost estimate of theBreeland Ltd. special order to include Josh’s purchaseof the remaining 10 gallons of XO-1600, what pricedetermination would she have arrived at? What impactwould that have had on Ace Fertilizer’s bottom line?IM A ED U C ATIO NA L C A S E JOURNAL4V OL. 2, N O. 3, ART. 3, SEPTEMBER 2009Table 1IMA Statement of Ethical Professional PracticeMembers of IMA shall behave ethically. A commitment to ethical professional practice includes overarching principles that express our values,and standards that guide our conduct.PrinciplesIMA’s overarching ethical principles include: Honesty, Fairness, Objectivity, and Responsibility. Members shall act in accordance with theseprinciples and shall encourage others within their organizations to adhere to them.StandardsA member’s failure to comply with the following standards may result in disciplinary action.I. CompetenceEach member has a responsibility to:1. Maintain an appropriate level of professional expertise by continually developing knowledge and skills.2. Perform professional duties in accordance with relevant laws, regulations, and technical standards.3. Prepare decision support information and recommendations that are accurate, clear, concise, and timely.4. Recognize and communicate professional limitations or other constraints that would preclude responsible judgment or successfulperformance of an activity.II. ConfidentialityEach member has a responsibility to:1. Keep information confidential except when disclosure is authorized or legally required.2. Inform all relevant parties regarding appropriate use of confidential information. Monitor subordinates’ activities to ensure compliance.3. Refrain from using confidential information for unethical or illegal advantage.III. IntegrityEach member has a responsibility to:1. Mitigate actual conflicts of interest, regularly communicate with business associates to avoid apparent conflicts of interest. Advise allparties of any potential conflicts.2. Refrain from engaging in any conduct that would prejudice carrying out duties ethically.3. Abstain from engaging in or supporting any activity that might discredit the profession.IV. CredibilityEach member has a responsibility to:1. Communicate information fairly and objectively.2. Disclose all relevant information that could reasonably be expected to influence an intended user’s understanding of the reports, analyses,or recommendations.3. Disclose delays or deficiencies in information, timeliness, processing, or internal controls in conformance with organization policy and/orapplicable law.RESOLUTION OF ETHICAL CONFLICTIn applying the Standards of Ethical Professional Practice, you may encounter problems identifying unethical behavior in resolving an ethicalconflict. When faced with ethical issues, you should follow your organization’s established policies on the resolution of such conflict. If thesepolicies do not resolve the ethical conflict, you should consider the following courses of action:1. Discuss the issue with your immediate supervisor except when it appears that the supervisor is involved. In that case, present the issueto the next level. If you cannot achieve a satisfactory resolution, submit the issue to the next management level. If your immediate superioris the chief executive officer or equivalent, the acceptable reviewing authority may be a group such as the audit committee, executivecommittee, board of directors, board of trustees, or owners. Contact with levels above the immediate superior should be initiated only withyour superior’s knowledge, assuming he or she is not involved. Communication of such problems to authorities or individuals not employedor engaged by the organization is not considered appropriate, unless you believe there is a
clear violation of the law.2. Clarify relevant ethical issues by initiating a confidential discussion with the IMA Ethics Counselor or other impartial advisor to obtain abetter understanding of possible courses of action.3. Consult your own attorney as to legal obligations and rights concerning the ethical conflict.