Accounting ACE Fertilizer Case Study

I M A E D U C AT I O N A L C A S E J O U R N A L V O L . 2 , N O . 3 , A R T. 3 , S E P T E M B E R 2 0 0 91

INTRODUCTION

Having a double undergraduate major in Accounting

and Integrated Supply Management and an MBA from a

renowned business school qualified Abby Conroy, CMA,

for her position at Ace Fertilizer Company. She has been

employed at Ace Fertilizer for the past three years, and is a

highly respected employee. Her hard work and dedication

to detail resulted in a series of rapid promotions. Currently,

Abby is assistant director of manufacturing and is primarily

responsible for special customer orders. Meeting the needs

of customers in manufacturing special orders has become

a very profitable portion of Ace’s operations. These special

orders sometimes complement, but more frequently are

totally unrelated to, Ace’s principal business of producing

lawn and garden fertilizer. Ace Fertilizer actively seeks

special orders in a highly competitive market, driven more

by quality and on-time completion than price. Ace has

established itself as an industry leader by consistently

meeting customer expectations.

The ability to meet the needs of customers through

manufacturing special orders was the concept of Ace’s founders,

and now passive owners, James Stegink and Norman Light.

Both have engineering degrees and are considered by many

to be quite the “tinkerers.” Abby reports to the director of

manufacturing, George Smilee. The manufacturing operations

are managed by Tom Brennen, the chief operating officer of

Ace Fertilizer.

In her role as assistant director, Abby is responsible for the

design, bidding, manufacture, and ultimate delivery of special

orders to customers. Abby develops and completes all special

order contracts. George Smilee initials his approval of these

contracts. Completed, initialed customer contracts then proceed

to Tom Brennen for his ultimate approval and signature.

All special orders at Ace Fertilizer follow a prescribed

billing formula. These special orders, unless specific

authorization is obtained from Tom Brennen himself,

must be billed at 80 percent over the cost of the order.

Tom Brennen rarely allows exceptions to this formula,

as sufficient demand exists for Ace Fertilizer’s operating

capacity. Although Ace maintains an extensive raw materials

inventory, on occasion these special orders require Abby to

order materials specific to the order. These materials are

acquired in the most economical order quantity available.

The special order is billed for the entire cost of the specially

ordered materials, even if unused quantities remain.

Customers are given the option of keeping these unused

materials, but virtually all companies decline. An exception

to that policy is only allowed when another confirmed order

exists when the initial order is signed that requires the use

of those excess materials. In that case, Tom Brennen, as a

matter of fairness, insists that the cost of those materials be

prorated among special orders.

What Abby likes especially about Ace Fertilizer is its

family atmosphere. In fact, Abby has been invited several

times by George Smilee to his family get-togethers. George

is close to his family, most of whom live within a 10-mile

radius. The family has regular get-togethers attended

faithfully by George and his two brothers. George’s family

has become very close since the untimely death of George’s

father last year. His brothers are all self-employed in a

variety of businesses, and on occasion Ace Fertilizer does

special orders for them.

1

ISSN 1940-204X

Ace Fertilizer Company: Ethical Cost Allocations and Price Determination Jerry Kreuze

Western Michigan University

Sheldon Langsam

Western Michigan University

Abby has become very skilled at computing the cost of

special orders. She fully realizes a special order includes a

variety of costs, including direct and indirect costs. Abby

knows that proper project cost determination mandates

inclusion of all of these costs.

DIRECT COSTS vS. INDIRECT COSTS

Direct costs are those costs that are easily and conveniently

assigned to a special order. Major direct costs for Abby

are direct materials and direct labor. Direct materials are

those materials that become an integral part of the finished

product. Direct labor, sometimes referred to as “touch

labor,” includes the cost of those laborers who directly

touch the product while it is being made. The wages of

general production employees who are idled due to machine

breakdown are classified as indirect costs.

Direct costs are usually variable and change as production

volumes change. Thus, direct materials and direct labor are

typically variable costs. For special orders, some direct costs

can be fixed, however. The costs (depreciation, electricity, and

routine maintenance) associated with a machine dedicated to

one product are direct costs of that product.

Indirect costs cannot be easily and conveniently assigned

to a special order. Rather, these costs are common costs, in

that they are incurred to produce a variety of special orders.

Maintenance costs of general purpose equipment, the

supervisor’s salary, and utilities are direct costs needed to

produce special orders in general, but are indirect costs for a

particular special order. Moreover, general production costs,

including property taxes, insurance, lawn care, cafeteria

costs, and miscellaneous supplies consumed in production

are indirect costs properly allocated to special orders

manufactured.

ALLOCATION Of INDIRECT COSTS

Abby could allocate indirect costs to special orders using a

company-wide overhead rate. Frequently, these indirect costs

are allocated by selecting an allocation base common to all of the

company’s products or services. Many companies base overhead

allocations on direct labor-hours or machine-hours. Abby realizes,

however, that this allocation process is troublesome as it is

impractical to trace these costs to specific orders.

Alternatively, Abby could allocate indirect costs to special

orders using activity-based costing (ABC). Rather than

simply allocating indirect costs among special orders using a

company-wide rate, ABC acknowledges that not all costs are

driven by output volume. As a result, information is available

to help determine the most profitable special orders and

customers, which activities and processes are value-added,

and where efforts toward improvements can be made. Abby

especially likes this latter approach when assigning indirect

costs to special orders.

BREELAND LTD. SpECIAL ORDER

The Cost Estimate. Abby has received a request from Breeland

Ltd. to produce a unique, somewhat unstable cleaning solvent

for use in Breeland’s specialized steel plating process. Ace

Fertilizer is one of only a handful of companies across the

country capable of producing such a solvent. The customer

has a limited need for this solvent, and does not foresee

requiring quantities of it beyond this special order. To produce

this substance, Abby must purchase a specialty acid ingredient

known as XO-1600. That substance is only available in

50-gallon drums. The 50-gallon drum costs $80,000. This

special order will only require the use of 40 gallons. XO-1600

has a shelf life of only 20 days after the drum is opened. After

those 20 days, the substance becomes very unstable and must

be discarded. Because of the chemical nature of the substance,

it requires proper disposal. Abby estimates the cost of this

disposal at $10,000. Abby has checked existing, confirmed

orders and found none that will require XO-1600 within the

next 20 days. Inquiries with representatives at Breeland Ltd.

reveal that they have no interest in taking possession of the

unused gallons.

Abby also determines that several other costs and

activities will be associated with the completion of the

special 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 constraints

during the mixing process).

Using ABC at the beginning of the costing period, Abby

arrives 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 direct

materials, direct labor, unit-level activity costs, and

batch-level activity costs.

I M A E D U C AT I O N A L C A S E J O U R N A L V O L . 2 , N O . 3 , A R T. 3 , S E P T E M B E R 2 0 0 92

Toward the end of the day on Friday, Abby works up

the following cost estimate and price determination for this

special order:

Direct materials:

Non-XO-1600 $ 20,000

XO-1600: Purchase cost 80,000

Disposal cost 10,000

Direct labor 30,000

Unit-level activity cost ($40 * 4,000 gallons) 160,000

Batch-level activity cost ($5,000 * 4 batches) 20,000

Product-level activity cost 80,000

Customer-level activity cost 30,000

Organization-sustaining level activity cost

(20,000+80,000+10,000+30,000+160,000+20,000 320,000

Total costs of Breeland Ltd. special order $ 750,000

Markup on cost ($750,000/.80) 900,000

Total price Determination for Breeland Ltd. Order $1,650,000

Abby discusses this estimate and price quote with George

Smilee, who expresses preliminary approval. Abby fully

believes that Breeland Ltd. will accept this price quote. All

that is needed now is Tom Brennen’s formal approval and

signature. Before Abby and George leave for the weekend,

they both concur that it is highly probable that Breeland’s

special order will be approved next week. Details as to

production and completion dates will be finalized upon

approval of the special order.

The Weekend Family Get-Together. The Smilee clan has a get-

together planned for Saturday afternoon, and George informs

Abby 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, as

Grandma Smilee has just turned 80 years old. The weather

is just perfect for the gathering. George mingles with his

family and is truly enjoying himself. After the meal and

games, George spends some quiet time with his brothers.

He is sharing some of the details of the special order for

the solvent. When one of his brothers, Josh, hears George

mention the chemical XO-1600, he becomes very interested.

It turns out that he has recently been approached by a

customer to manufacture a spray-on rust inhibitor that

requires XO-1600 as an ingredient. The quantity needed

for that order is 8 gallons, but Josh thinks he can convince

the customer to expand his order to use all of the 10 gallons.

Josh briefly walks away from the group, calls his customer,

and confirms the order. Smiling, Josh informs George of the

news. The two agree to finalize this arrangement later in

the coming week.

Josh’s Project Price Determination. Early Monday morning,

George goes to Abby’s office to inform her of the development

with Josh over the weekend. He explains Josh’s intent to

purchase the remaining 10 gallons of XO-1600. George

indicates that the details of that agreement are to be finalized

later in the week. Pausing for a moment to fully understand

the details of this arrangement, Abby remembers and informs

George that the price quote last Friday assumed that the extra

10 gallons would remain unused and would require disposal,

and accordingly the order included the entire cost of the XO-

1600 plus the mandated disposal costs. Abby suggests that

Breeland Ltd. be informed of a slight delay in the price quote

and if Breeland agrees to the delay, then the initial order can

be revised in light of Josh’s forthcoming order.

To Abby’s surprise, George is very cold to the idea of

delaying the initial order. George contends that as of today,

there are no confirmed orders that would require the extra

10 gallons of XO-1600. In fact, there will be no confirmed

orders until later this week, when Josh meets with George

to finalize the weekend arrangement. Consequently, George

maintains that the special order as presently priced should

be forwarded to Tom Brennen for his approval and signature,

and if and when a formal order is received from Josh, that

order should simply include a prorated cost for the 10 gallons

of XO-1600 plus a profit markup on cost. George, in fact, is

elated and sees this as a windfall, as the 10 gallons of XO-

1600 can be billed twice and the billed disposal costs would

not be incurred. This pleasant turn of events adds $93,600

($16,000 for the 10 gallons of XO-1600, $10,000 of eliminated

disposal costs, $26,000 for organization-sustaining level

activity costs, and $41,600 for markup on the cost of the 10

gallons of XO-1600) to the company’s bottom line.

Abby fully realizes that she had already developed the

price quote for Breeland’s order the week before, and George

Smilee had expressed his approval. Since there were no

confirmed orders existing at that time for the unused portion

of the XO-1600, Abby, according to company policy, included

the entire acquisition cost plus disposal costs in the cost

estimate. Abby now knows that an order in all likelihood

will be obtained within the 20-day disposal period for the

remaining 10 gallons of XO-1600. Given this new information,

Abby believes that her original cost estimate should be

amended pending approval of a delay by Breeland Ltd.

I M A E D U C AT I O N A L C A S E J O U R N A L V O L . 2 , N O . 3 , A R T. 3 , S E P T E M B E R 2 0 0 93

Alternatively, Abby would like to submit a revised quote

to Breeland Ltd. if Josh’s order is finalized within 20 days.

Specifically, she would like to only bill Breeland Ltd. for 40

gallons of XO-1600, delete the disposal costs, and modify

the organization-sustaining and profit on cost amounts.

Josh would then be shipped the product and be billed for

the cost of the 10 gallons of XO-1600. Contrary to George’s

suggestion, Abby believes that Josh should also be billed an

appropriate organization-sustaining cost amount in addition

to a profit on cost. Even these amounts, however, would

result in a smaller profit margin for the special order and

would not allow the company to meet its monthly profit goal.

George Smilee seems adamant in his determination and has

instructed Abby to develop a quote for Josh independent

of the cost determination for the Breeland special order.

George is meeting with Tom Brennen the first thing on

Wednesday morning to get his approval and signature on the

special order. Abby is contemplating what course of action

she should take. She plans to rely, in part, on the guidance

provided by the Institute of Management Accounting (IMA)

in its Statement of Ethical Professional Practice, found in Table

1. Abby is wondering why George Smilee is not using this

same guidance. She wonders if George would be taking

a similar position if he also were a Certified Management

Accountant (CMA).

REqUIRED qUESTIONS

1. Did Abby compute the cost of the Breeland Ltd. special

order correctly before the weekend get-together? If not, how

was her cost estimate and/or price determination flawed?

2. Whose assessment of the costing of this special order

do you believe is correct—George Smilee’s or Abby

Conroy’s? That is, should George’s conversations with

Josh impact Abby’s cost estimate of the Breeland Ltd.

special order? Explain your answer.

3. Are there any ethical issues related to the cost determination

on the Breeland Ltd. special order? If so, what issues

are present? How should Abby resolve these conflicts?

Should Abby go directly to Tom Brennen about this new

development? How can Abby use the IMA Statement of

Ethical Professional Practice as a guide for her actions?

4. If Abby were to modify her original cost estimate of the

Breeland Ltd. special order to include Josh’s purchase

of the remaining 10 gallons of XO-1600, what price

determination would she have arrived at? What impact

would that have had on Ace Fertilizer’s bottom line?

I M A E D U C AT I O N A L C A S E J O U R N A L V O L . 2 , N O . 3 , A R T. 3 , S E P T E M B E R 2 0 0 94

ABOUT IMA With a worldwide network of nearly 60,000 professionals,

IMA is the world’s leading organization dedicated to

empowering accounting and finance professionals to drive

business performance. IMA provides a dynamic forum for

professionals to advance their careers through Certified

Management Accountant (CMA®) certification, research,

professional education, networking and advocacy of the

highest ethical and professional standards. For more

information about IMA, please visit www.imanet.org.

I M A E D U C AT I O N A L C A S E J O U R N A L V O L . 2 , N O . 3 , A R T. 3 , S E P T E M B E R 2 0 0 95

Table 1 IMA Statement of Ethical Professional Practice

Members of IMA shall behave ethically. A commitment to ethical professional practice includes overarching principles that express our values, and standards that guide our conduct.

Principles

IMA’s overarching ethical principles include: Honesty, Fairness, Objectivity, and Responsibility. Members shall act in accordance with these principles and shall encourage others within their organizations to adhere to them.

Standards

A member’s failure to comply with the following standards may result in disciplinary action.

I. Competence

Each 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 successful

performance of an activity.

II. Confidentiality

Each 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. Integrity

Each member has a responsibility to: 1. Mitigate actual conflicts of interest, regularly communicate with business associates to avoid apparent conflicts of interest. Advise all

parties 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. Credibility

Each 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/or

applicable law.

RESOLUTION OF ETHICAL CONFLICT

In applying the Standards of Ethical Professional Practice, you may encounter problems identifying unethical behavior in resolving an ethical conflict. When faced with ethical issues, you should follow your organization’s established policies on the resolution of such conflict. If these policies 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 issue to the next level. If you cannot achieve a satisfactory resolution, submit the issue to the next management level. If your immediate superior is the chief executive officer or equivalent, the acceptable reviewing authority may be a group such as the audit committee, executive committee, board of directors, board of trustees, or owners. Contact with levels above the immediate superior should be initiated only with your superior’s knowledge, assuming he or she is not involved. Communication of such problems to authorities or individuals not employed or 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 a better understanding of possible courses of action.

3. Consult your own attorney as to legal obligations and rights concerning the ethical conflict.