Sippican Corporation (a)

Question 1: Given some of the apparent problems with Sippican’s cost system, should executives abandon overhead assignment to products entirely and adopt a contribution margin approach in which manufacturing overhead is treated as a period expense? Why or why not?

Sippican Corporation faces a decline in their operating income, which decreased from historically 15% to 1,8% in March 2016. Coming from a point of innovation leadership enabled by outstanding precision in production processes, Sippican Corporation is faced with increased competition and therefore had to adapt prices.

Price reductions for pumps and valves directly led to margin decreases. These margins are measured with a simple cost accounting system. The accounting system allocates a fixed percentage (185%) of the products direct labor costs as a manufacturing overhead. This method is so far advantageous because it is easy to implement and inexpensive to carry out. However, the complexity of the production process and the associated costs for the individual products are not taken into account. This is problematic because there is no linear connection between the direct labor costs and the overhead capacity for Sippican’s product lines. Therefore, the currently calculated total manufacturing overhead does not reflect the actual costs per product group.

In order to overcome this postponed cost allocation, an alternative costing system should be adapted. An abandon of overhead assignments as mentioned by executives of Sippican would not help to resolve the issue. With 36% the manufacturing overhead is a large percentage of the overall costs. Treating manufacturing overhead costs as period expense does not solve the problem, as no information is generated to improve costs and profitability. Thereby neither deep insights into the cost structure or profitability of the individual product groups, nor into the connections between complexity of the processes, production volume and direct labor, are created. For these reasons, it is necessary to look for another alternative.

Kaplan's activity-based costing approach should be applied to the use case of the Sippican Corporation. Activity-based costing helps Sippican to gain the needed insights to analyze the cost and profitability structure of their product lines. The method breaks down the production process into activities and measures the effort required (Kaplan & Anderson, 2016). In the Sippican case, this is particularly useful because the production process has a low complexity and the required information is already available. This means that a cost-effective adaptation of activity-based costing can be implemented quickly. In this case, the time-driven approach is preferable to the pure activity-based approach because of its simplicity.

Question 2: What are the practical capacity (total hours per month) and the capacity cost rates ($ per hour) for each of Sippican’s resources: production and setup employees, machines, receiving and production control employees, shipping and packaging employees, and engineers?

The practical capacity in Exhibit 1 is calculated as follows: The number of workers is multiplied with their effective work time. To receive the practical capacity per day we have to double the result because two shifts are worked a day. To scale the result to hours per month the capacity per day is multiplied by 20, which represents the days worked per week.

Exhibit 1: Practical Capacity

To now determine the capacity cost rates shown in Exhibit 2 the number of workers are multiplied with the monthly compensation. The total compensation is than divided by the practical capacity calculated in Exhibit 1.

Exhibit 2: Capacity cost rate

Question 3: Using these capacity cost rates and the production data in Exhibits 3 and 4, what are the revised costs and profits for Sippican’s three product lines? What differences does your cost assignment have on reported production costs and profitability? What causes the shift in cost and profitability?

The time-driven activity-based costing was used to update the costs and profits for the product lines of Sippican Corporation for a representative month.

Exhibit 3: Costs and profitability (in $) product line based