Fort Erie Consumer Products
Fort Erie Consumer Products manufactured a wide range of consumer products. To support all aspects of its acquisition, manufacturing, distribution, and marketing operations, the company maintained a graphics department. This department, called the Corporate Graphics Department, employed graphics designers and maintained and operated its own printing equipment.
The company was organized on a responsibility basis. The method of evaluating the various responsibility centers varied. Some of the centers were evaluated as cost centers, others as profit centers, and still others as investment centers.
When the Corporate Graphics Department was first established in 1994, there was relatively little interest in, or demand for, the products of the department. To encourage the use of these graphics capabilities, management decided not to charge the services and products of the graphics department to users. By mid-1995, the Corporate Graphics Department was running at capacity and was issuing requests to buy more sophisticated (and very expensive) printing equipment There was some concern that the graphics department was empire building in the sense that it was acquiring equipment that was technologically elite but had no obvious or legitimate use in his the film.
To provide some control over the Corporate Graphics Department, Maureen Jackson, the vice president of finance, decreed in early 1996 that the Corporate Graphics Department would be run as a cost center. That is, Martin Roy, the manager of the Corporate Graphics Department, would be evaluated on the basis of his ability to control the department’s costs relative to budgeted, or standard, costs for the work done. Moreover, to exercise some control on the empire-building inclinations of the graphics department, she declared that the department would be required to charge out all its costs to users. That is, the graphics department was to become customer-driven in the sense that it could not incur any costs that would not be reimbursed by customers.
In response to the vice president’s decision, Martin developed a charge rate for his department. Martin decided that there were two classes of costs in his department: materials costs and overhead costs (which consisted of all the costs other than materials costs in the Corporate Graphics Department). In 1995, the graphics department had undertaken 12,736 jobs and had incurred materials costs of $6,704,948 and overhead costs of $5,678,346. There were many components of overhead costs, but the primary components of overhead costs were equipment and equipment-related costs of $3,586,239 and salary costs of $1,408,376.
The decision was made that the charge for any job would be the out-of-pocket materials costs for doing the job, plus an allocation to cover the overhead cost. The materials cost for any job was readily available from the job-cost sheet maintained for each job. The overhead rate for each job was computed by taking the overhead cost per job in the preceding year and adding 10%. Therefore, this rate in 1996 would be $490.44 per job. Martin provided the following rationale for his decision:
This method is simple and easy to implement. It requires that each job absorb its own materials costs plus bear its fair share of the overhead of the Corporate Graphics Department. The 10% uplift of costs is needed to cover the installation and breaking- in costs of the new equipment that is not yet operational that we feel we ought to continually acquire in order to provide a full range of printing capabilities. We think of these costs as the research and development costs that we have to incur so that we can educate ourselves and our customers about how to use the state-of-the-art equipment that we are buying.
In 1996, for the first year since the Corporate Graphics Department had been created, demand for jobs fell off. In an attempt to discover what had happened, Maureen Jackson commissioned a special study of users. Although there were many complaints—including dissatisfaction with the timeliness of the work done, the quality of the work done, and the willingness of the Corporate Graphics Department to listen to and meet the customers’ needs—the major complaint was cost. The following comment from Paul Tremaine, the manager of the Safety Department, summarized many of the criticisms:
I’m tired of dealing with these guys. They spend all their time trying to talk us into using their fancy equipment. They have about twelve pieces of printing equipment in there, most of which are doing things that we will, never need. We have specific needs, dictated by employee safety standards and requirements, for graphics materials. I do need graphics consultants and fancy offset printing. I need visibility and coverage provided economically. We know what we want; we just cannot print it ourselves. And their prices—well, they are way out of line. I have a specific budget for printing safely posters and I am going to take my business outside. I can get the same job done outside for about half the cost that 1 am expected to pay internally.
On the other hand, the comments of some users were very positive. The director of new promotions in the Marketing Department made the following comments:
I think that their service is great. Their graphics consultants are great—creative and innovative. They take their time and provide outstanding artwork and high-quality graphics, And the cost is next to nothing; we would have to pay almost ten times as much for the same service outside.
In response to these comments, in early 1997 Maureen Jackson directed one of her staff consultants to undertake a preliminary analysis of the situation and provide some alternative approaches to dealing with the problems identified. The gist of the consultant’s report was that the cost allocations did not reflect the actual demands and usage of the Corporate Graphics Department. Moreover, the consultant pointed out that conventional cost accounting wisdom required that fixed costs and variable costs be charged and allocated separately. Variable costs should be allocated on the basis of actual usage, and fixed costs on the basis of planned usage. The consultant pointed out that, under the current scheme, materials costs were allocated on the basis of actual cost, whereas fixed and variable overhead costs were allocated on the basis of actual usage. That approach, the consultant pointed out, might create problems.
Required
(1) What benefits might accrue from allocating fixed costs on the basis of planned usage and variable costs on the basis of actual usage?
(2) Should standard or actual costs be allocated in a charge-out system such as this?
(3) Explain why the scheme developed by Martin Roy does not fulfill Maureen Jackson’s intention that the cost-charging scheme should control the Corporate Graphic Department’s empire-building tendencies. What evidence is there of the failure to meet that objective?
(4) What would you recommend to provide the Corporate Graphics Department with a more effective motivation to operate effectively and efficiently?
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