HBSP Product Number TCG031 THE CRIMSON PRESS CURRICULUM CENTER THE CRIMSON GROUP, INC. ScarpeItaliane, S.p.A. Is this diversification move good or not? First you tell me that machine-made shoes are money makers, then you tell me we’re losing a bundle o

HBSP Product Number TCG031

THE   CRIMSON    PRESS   CURRICULUM   CENTER

THE  CRIMSON   GROUP,   INC.

ScarpeItaliane, S.p.A.

Is this diversification move good or not? First you tell me that machine-made shoes are money makers, then you tell me we’re losing a bundle one achpair Which is it?

The speaker was Francesca Nadalini, CEO of Scarpe Italiane, S.p.A.(SISPA). SISPA had been manufacturing shoes in Italy for several generations. Three years ago, Ms. Nadalini had completed her B.S .in Business Administration, and had been asked by her father, the company’s president, to initiate SISPA’s North American operations. She commented:

We’ve grown a lot and done well in the past three years. Most of our shoes are handmade, using very little in the way of machines, and we charge a premium price for them. Recently, however, we decided to diver-sify so we could compete with the more automated manufacturers. We purchased some specialized equip-ment that we installed in our plant and that we use only for the machine-made shoes. We use very little la-borto  make these kinds of shoes. The problem now is that we don’t seem to know how much it costs us to make either kind of shoe. It was easy when we produced only handmade shoes, but matters are now much more complicated. The problem seems to be with overhead allocation.

SISPA’s overhead costs and some related information, are shown in Exhibit1.GiovanniHoff-man, SISPA’s chief accountant, commented on the nature of the problem:

When we produced only hand made shoes, we allocated all our manufacturing overhead [MOH] to the mand there was no problem. Our MOH is relatively high, since receiving and handling the materials from each leather shipment takes a lot of time. Also, a spartofreceivingandhandling,wecutandpreparemuchoftheleatherbeforeitentersmanufacturing,allofwhichweconsidertobemanufacturingoverhead.

Theshifttomachine-madeshoeshasmeantmorethanjustsomeincreaseddepreciation,whichweconsidertobeadirectcost,sinceweusecompletelydifferentmachinesformachine-madeshoesthanforhandmadeones.Inaddition,however,allthemachinesneedtoberepairedandmaintained,whichseemstobeafunctionofthenumberofhoursthateachmachineisused.Ourrepairandmaintenancecrewworksonallofthemachines,soweconsiderthemtobepartofmanufacturingoverhead.

Thenthere’ssetuptimeforthemachines,whichisrelatedtothenumberofbatcheswerun.Thehand-madeshoesarestitchedandformedindividually,butthenfinisheduponamachineinbatches.And,ofcourse,allofthemachine-madeshoesareruninbatches.Abatchisagroupofshoesofthesamesize,andwehavetosetupthemachinestoaccommodatetheparticularsize.Oursetupcrewworksonallofthema-chines,soweconsiderthemtobepartofmanufacturingoverheadalso.

Ms.Nadalini’sconcernaboutcostsarosebecauseMr.Hoffmanhadpresentedher withsomeconflictinginformation. Initially,Mr.Hoffmanhadallocated overheadtoshoesonthebasisofdi-rectlabordollars,asshowninExhibit2. Then,decidingthatmachinehoursdrovetheuseofmuchoftheoverhead,hehadusedmachinehourstoallocatetheoverhead,asshowninExhibit3.Ms.Nadalinicommented:

Withthefirstapproach,Iwaspleased.Themachine-madeshoeswereshowingabiggermarginpercentthanthehandmadeones,whichdidn’tcompletelymakesensetome,sincethemarketformachine-madeshoesismuchmorecompetitivethanthemarketforhandmadeshoes,butIthoughtthatperhapsweweredoingsomethingbetterthanourcompetitors.Thenalongcomesthereportusingmachinehoursastheba-sisforallocatingoverhead.Wow!Themarginpercentonourhandmadeshoesisterrific,butwe’relosingabundleonthemachine-madeones.

ThiscasewaspreparedbyProfessorDavidW.Young.Itisintendedasabasisforclassdiscussionandnottoillus-trateeithereffectiveorineffectivehandlingofanadministrativesituation.

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Ontopofallofthis,Giovannihastoldmethat,becausewehavesomuchfixedmanufacturingover-head,weshouldbeusingvariablecosting,andhe’sputtogetherasetoffinancialstatementsusingvariablecostingthatshowswe’relosingmoney[Exhibit4].Thisjustdoesn’tmakesense,althoughIsupposeifthemarginsonthemachine-madeshoesareasbadastheynowseemtobe,maybeit’strue.Ifso,though,whydoesn’tthelossshowupontheabsorptioncostingstatement?

Atthispoint,I’mnotsurewhattodo.We’vejustbegunproducingmachine-madeshoes,andaremakingonlyafewhundredpairsrightnow,butthisproblemcouldgetmuchbiggerifweincreaseproduc-tion.Mysense isthatweshouldgetoutofthemachine-madeshoebusiness,andstickwithhandmadeshoes.Weweredoingprettywellatthatbeforewebegantodiversify.Itseemsasthoughwe’vemadeabigmistake.Ormaybeit’sallintheaccounting.

Assignment:

1.        Compute the allocation  rate that was used for manufacturing overhead in Exhibits 2 and 3. Using these rates, show the computations that were used for allocating manufacturing overhead in Exhibits 2and 3.

2.        Exhibit 4 shows a negative $15,000 overhead volume variance. Explain why it exists and why it is negative.

3.        Exhibit 4 also shows a positive $2,800 overhead budget variance. What are the potential causes for it?

4.        In Exhibit 4, the operating income is larger under absorption costing than under variable costing. Why Please be very explicit in explaining the reason(s) for the difference.

5.        Use the information in Exhibit 1 to identify cost drivers and compute manufacturing over head rates for machine maintenance, machine setup labor, and material handling. Use these overhead rates to calculate the cost of goods manufactured for a pair of machine- made shoes and a pair of handmade shoes, and compute the margin percent ages for each.

6.        Ms. Nadalini has asked you if SISPA should get out of the machine-made shoe business. What do you recom-mend and why?