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 on each pair. Which is it?

The speaker was Francesca Nadalini, CEO of Scarpi Italiani, Inc. (SII). SII 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 SII’s North American operations. She commented:

We’ve grown a lot and done well in the past three years. Most of our shoes are hand made, using very little in the way of machines, and we charge a premium price for them. Recently, however, we decided to diversify so we could compete with the more automated manufacturers. We purchased some specialized equipment that we installed in our plant and that we use only for the machine-made shoes. We use very little labor to 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 hand-made shoes, but matters are now much more complicated. The problem seems to be with overhead allocation.

SII’s overhead costs and some related information, are shown in Exhibit 1. Giovanni Hoffman, SII’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 them and 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, as part of receiving and handling, we cut and prepare much of the leather before it enters the manufacturing process, all of which we consider to be manufacturing overhead.

The shift to machine-made shoes has meant more than just some increased depreciation, which we consider to be a direct cost, since we use completely different machines for machine-made shoes than for hand-made ones. In addition, however, all the machines need to be repaired and maintained, which seems to be a function of the number of hours that each machine is used. Our repair and maintenance crew works on all of the machines, so we consider them to be part of manufacturing overhead. . . .

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 2 and 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 overhead rates for machine maintenance, machine set up 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 hand-made shoes, and compute the margin percentages for each.
6. Ms. Nadalini has asked you if SII should get out of the machine-made shoe business. What do you recommend and why?