Arctic Insulation is a company that uses scrap paper along with fiber to produce insulation material used in home attics. They have two sources of the paper used to produce insulation; bulk paper from scrap dealers, and buying paper from the public at nominal rates. The direct labor cost for processing the bulk paper is much higher at $3. 84 per bale compared to $. 60 per bale for the purchased bales. The price per pound of scrap paper varies significantly based on market conditions.
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The unit cost per bale appears to be falling which would agree with the General Manager’s alternative cost report. It’s hard to accurately compare the costs of producing each bale if total costs aren’t taken into account. Basing the overhead costs on a percentage of direct labor vastly understates overhead for the purchased bales, since a larger percentage of the total cost is the cost to purchase paper. Since the cost of purchasing paper is collected at the divisional level, it isn’t considered in this calculation.
Taking a total of the depot and divisional overhead values and dividing them by the total number of bales produced and adding that figure to an actual direct labor cost per bale would produce a more accurate total overhead value. In 1979, the total unit cost per bale was ($10,697,050/1,355,000) $7. 89. In 1980, the total unit cost per bale was ($9,636,970/1,650,000) $5. 84. Using the General Managers method of distributing overhead, the cost per formed bales in 1979 was $8. 56 while the cost per purchased bale was $5. 32.
In 1980 the cost per formed bale was $7. 53 while the cost per purchased bale was $4. 29. These calculations agree with the General Managers table and can be found on the attached spreadsheet. This decrease in the production cost per bale was caused by an increase in purchased bales, which have a much lower direct labor cost. The cost control issue that the President was concerned with involved an increase in salaries of 6% in 1980. It is unknown if this wage increase was necessary to keep the employees on the payroll. The market forces weren’t discussed.
If the unemployment rate was low and the employees could easily find work elsewhere, the increase in salaries may have been warranted. The increase in depot overhead includes the 6% increase in the wages of the 22 foremen and the wages of the forklift drivers. Expenses like Social Security that are based on a percentage of income also add to the increase in depot overhead. The increase in direct labor includes the 6% increase of the wages of all other employees. The increase in efficiency appears to compensate for the increase in overhead.
This doesn’t appear to be a serious issue since total costs per unit have decreased from 1979 to 1980, although it is cutting into the profit margin. I would recommend the summary cost reports for the collection and bailing depots shift from the current format to one resembling the General Manager’s alternative report. Allocating overhead based strictly on a percentage of direct labor makes the cost report seriously lopsided. The depot and division overhead should be based on an average cost per unit and the direct labor should be based on an actual cost per unit.
This method streamlines the costs and distributes the overhead more evenly. I would recommend including data showing the amounts paid for purchased bales and scrap paper in the report. Although the costs of purchasing paper are not charged to the depots, they are relevant when making managerial decisions. The president should change the cost report format and keep current operating procedures the same because they’re profitable. One possible improvement could be to stockpile bulk paper purchased from scrap dealers when the volatile prices drop below a certain point.
This method is currently used by the aggressive scrap paper companies to hedge risk, and Arctic could also take advantage of these savings if they have any extra storage space. This would be an excellent way to save on direct labor costs while keeping total costs low. In the case, no prices for scrap paper were given. The price would determine how big of a percentage impact a $. 015 per pound premium on paper purchased from dealers would be over scrap paper purchased at loading docks. Using historical information for the spot prices of scrap paper, in the 1979 to 1980 timeframe, spot prices ranged from $20 to $60 per ton.
The $. 015 premium becomes more of an issue the cheaper paper is available for purchase at the loading dock. At a spot price of $20 per ton or $. 01 per pound, the $. 015 per pound premium is 150% of the spot price. At this level, management should be focusing on casual purchases at loading docks. At a spot price of $60 per ton or $. 03 per pound, the $. 015 premium is 50% of the spot price. Rationalizing the premium will depend on which method is used to compute the cost per bale. When using the original cost report formula, the purchased bales were still cheaper after adding the $. 15 per pound premium at all spot prices between $20 and $60 per ton. The prices for purchased bales ranged from $9. 12 to $15. 12 while the prices for formed bales ranged from $10. 41 to $19. 41. The purchased bales were more expensive at all spot prices between $20 and $60 per ton when computing costs using the formula proposed by the General Manager. Using the alternate cost report formula, total costs ranged from $10. 63 to $16. 63 per formed bale and $11. 79 to $17. 79 per purchased bale. Calculations can be found on the attached spreadsheet.