Ace Fertilizer Company: Ethical Cost Allocations and Price Determination

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I M A EDUCATIONAL CASE JOURNAL

1

V OL. 2, N O. 3, ART. 3, SEPTEMBER 2009

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.

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.

DIRECT COSTS vS. INDIRECT COSTS

BREELAND LTD. SpECIAL ORDER

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.

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

ALLOCATION Of INDIRECT COSTS

during the mixing process).

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
IM A ED U C ATIO NA L C A S E JOURNAL

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.

2

V OL. 2, N O. 3, ART. 3, SEPTEMBER 2009

Toward the end of the day on Friday, Abby works up
the following cost estimate and price determination for this
special order:

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,

Direct materials:
Non-XO-1600

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 XO1600 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 XO1600 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.

$ 20,000

XO-1600: Purchase cost

80,000

Disposal cost

10,000

Direct labor

30,000

Unit-level activity cost ($40 * 4,000 gallons)
Batch-level activity cost ($5,000 * 4 batches)

160,000
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
Total costs of Breeland Ltd. special order
Markup on cost ($750,000/.80)

320,000
$ 750,000
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.
I M A ED U C ATIO NA L C A S E JOURNAL

3

V OL. 2, N O. 3, ART. 3, SEPTEMBER 2009

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).

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.

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?

IM A ED U C ATIO NA L C A S E JOURNAL

4

V OL. 2, N O. 3, ART. 3, SEPTEMBER 2009

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.

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