Plastic Film Extrusion, Inc.
A Mid-size Extruded Plastics Company
This company produces extruded plastics 70% for the healthcare market and 30% for the hygiene market. It produces 200 products in 60 product families using 10 extrusion lines; one converting line that uses 2 sheet cutting lines, one perforator, and one rewinder; and 5 support departments – shipping, materials management, quality, maintenance, and administration.
It used traditional standard costing for both its financial reporting and management/operating decisions and was experiencing two problems:
product cost fluctuations based on volume and product mix
products manufactured on new, faster, higher quality, labor and energy efficient machines were being costed higher than products manufactured on older lines.
The first issue was creating planning difficulties with the corporate staff, and the second issue was frustrating operations and general management since the new machines were being underutilized.
These problems had serious consequences. The first issue resulted in sales not knowing which products to focus on to improve the companies profit margins. The second issue resulted sales people offering price concessions to customers when salesmen could be sure the order would be filled on the older production line since sales commissions were awarded based on gross margin. It was clear to everyone, but not the costing system, that this practice was decreasing revenue and increasing costs.
The source of the problems was:
the oversimplified allocation of large pools of overhead with generalized, non-causal drivers;
the use of financial statement depreciation for product cost assignment ( the old equipment was fully depreciated, the new equipment was being allocated the same depreciation allowed for taxes which was very large in the first few years);
the failure to correctly identify and apply fixed and proportional costs for decision making, and the allocation of excess capacity costs to product cost.
Applying causal decision support costing concepts, rather than the minimal requirements of generally accepted accounting principles and regulatory financial reporting, resulted in:
stable product cost and significant changes in individual product contribution margin which allowed sales/marketing to improve focus and profitability (and eliminate “gaming” commissions);
substantiated the business case and investment in the new equipment and made future investments in new equipment more likely; and
improved the plant-wide communications and commitment to quality and financial goals.