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Cost Allocation Theory at Durango Plastics

Durango Plastics:
SCX is a $2 billion chemical company with a plastics plant located in Durango, Colorado. The Durango plastics plant of SCX was started 30 years ago to produce a particular plastic film for snack food packages. The Durango plant is a profit center that markets its product to film producers. It is the only SCX facility that produces this plastic.

A few years ago, worldwide excess capacity for this plastic developed as a number of new plants were opened and some food companies began shifting to a more environmentally safe plastic that cannot be produced with the Durango plant technology.

Last year, with Durango's plant utilization down to 60 percent, senior managgement of SCX began investigating alternative uses of the Durango plant. The Durango plant's current 2008 annual operating statement is as follows:

Revenue: $36
Variable Cost: (21)
Fixed Cost - Plant admin: (17)
Fixed Cost - Depreciation: (5)
Net loss before taxes: (7)

One alternative use of the Durango excess capacity is a new high-strength plastic used by the auto industry to reduce the weight of cars. Additional equipment required to produce the auto-motive plastic at the Durango plant can be leased for $3 million per year. Automotive plastic revenues are projected to be $28 million and variable costs are $11 million. Additional fixed costs for marketing, distribution and plant overhead attributable solely to auto plastics are expected to be $4 million.

All of SCXs divisions are evaluated on a before-tax basis.

a. Evaluate the auto industry plastic proposal. Compare the three alternatives: (i) close Durango, (ii) produce only film plastic at Durango, and (iii) produce both film and auto plastic at Durango. Which of the three do you suggest accepting? (If Durango is closed, additional one-time plant closing costs just offset the proceeds from selling the plant.)

b. Suppose the Durango plant begins manufacturing both film and auto plastic. Prepare a performance report for the two divisions for the first year, assuming that the initial projections are realized and the film division's 2009 revenue and expense are the same as in 2008. Plant administration ($17 million) and depreciation ($5 million) are common costs to both the film and auto plastics divisions. For performance evaluation purposes, these costs are assigned to the two divisions based on sales revenue. All costs incurred for the Auto Plastics division should be charged to that division.

c. Does the performance report in (b) reflect the relative performance of the two divisions? Why or why not?

d. In the year 2010, the Durango plant is able to negotiate a $1 million reduction in property taxes. Property taxes are included in the "plant administration account". In addition, the Film Division is able to add $3 million in additional revenues (with $2.1 of additional variable costs) by selling film to European food packagers. Assuming that these are the only changes at the Durango plant between 2009 and 2010, how does the Auto Plastics Divisions performance change between these two years? Allocate the common costs using the method described in (b).

Solution Summary

Cost allocation theory at Durango Plastics is examined.