Question

Ethical Issues Surrounding Activity-Based Costing^*

Xavier Auto Parts, Inc. manufactures a wide range of auto parts, which it sells to auto manufacturers, primarily in the United States and Canada.^* The company’s Engine Parts Division operated three plants in South Carolina and specialized in engine parts. The division’s Charlotte plant manufactured some 6,500 different parts.

Trouble Brewing

Both the Engine Parts Division, as well as the Charlotte plant in particular, had shown satisfactory profitability for the past 20 years. In 2009, however, the Charlotte plant’s profitability took a sharp downward turn, in spite of rising sales. The trend continued through the next several years. Management at both the division and plant levels took note of the plant’s declining profits and held several strategy meetings as a result.

Division Strategy

The Engine Parts Division had always positioned itself as the industry’s full-line producer. If a customer wanted a product, the division would make it. Although occasionally very-low-volume products were discontinued due to lack of consistent orders, the division’s product line remained a full line of engine parts. As part of its strategy review, division management did two things. First, an activity-based costing study was initiated in the Charlotte plant in order to give management a better picture of each product line’s profitability. Second, a high-level review was undertaken to determine whether the full-line-producer strategy continued to make sense.

Activity-based Costing

An ABC project team was formed, and a successful pilot study was conducted on two of the Charlotte plant’s product lines. Then the ABC project was extended to the entire Charlotte operation. Management was astonished to find that fully a quarter of the plant’s products were selling at a loss. Moreover, the ABC project highlighted the extent of the product-line proliferation at the Charlotte plant. It turned out that in many instances, unprofitable products had been dropped only to creep back into the product line-up after a customer requested it and a salesperson acquiesced. It became a joke around the plant that the only way to be sure a dropped product was really gone was to burn the engineering drawings and destroy the special tools required to make it.

ABC Team Recommendations

The ABC project team made sweeping recommendations to division management, which suggested that the Charlotte plant’s product lines be pruned and that roughly 20 percent of its products be dropped. New emphasis would then be devoted to increasing the profitability of the remaining 80 percent of the Charlotte plant’s products. Attention would be given to identifying inefficient processes, and process improvements would be evaluated.

Top Management Response

Top management balked at the recommendations of the ABC project team. Some top managers did not believe the ABC results. It just seemed impossible to them that so many of the Charlotte plant’s products were losers. Other members of the management team largely accepted the validity of the ABC study, but they, too, hesitated to drop so many products. To do so would most likely have meant massive layoffs and even the possibility of closing the Charlotte plant altogether, while shifting its remaining production to the division’s other two plants. Some members of the ABC project team quietly speculated that some of the division’s managers were more concerned about their own pay and perks than they were about the well-being of the division. In the final analysis, only a handful of products were dropped, and then only if they were suspected to be unprofitable before the ABC study was undertaken.

Aftermath

The Charlotte plant’s profits continued to deteriorate, as did the Engine Parts Division’s profitability. Eventually, Xavier’s corporate management cut its losses by selling off the Engine Parts Division to a competitor at bargain-basement prices. The division’s new owners closed the Charlotte plant and changed the division’s focus to be a boutique producer of high-quality engine parts, which was more in line with its own corporate strategy.

Ethical Issues

What ethical issues do you see in this scenario? How would you resolve them?

Answer 1

The ethical issues seen in this scenario are mentioned below:

- Charlotte division was constantly reporting losses despite increasing sales. To analyze the cause for this, an ABC team was formed.

-They came to the conclusion that a quarter of the Charlotte plant's products were selling at a loss. The reason for declining profits was due to rise in the sale of unprofitable products.

-Even the discontinued products would somehow creep back into the production line due to lack of internal controls.

- The primary ethical issue in front of the management was whether it should discontinue so many of the charlotte plant's products.

-This would result in massive lay-offs and the division might have had to be shut down altogether.

-The ethical dilemma here was whether to continue loss making products and cause harm to the financial health of the company or whetther to save jobs.

I would resolve the ethical issues in the following manner:

-Every company primarily operates for the purpose of making profits. Keeping this goal in mind, there is no choice but to discontinue the unprofitable products. Another option is to look at the costing and pricing. If the products can be made profitable by reducing the cost or restructuring the prices, there would be no need to discontinue them.

-If the products are discontinued, then I would suggest that some of the employees be transferred to the other two plants and some of them to other profitable product lines. However, it will not be possible to save all jobs, although I would make an effort to save as many as I can.