Alflonnso is a large producer of industrial chemicals, with divisions in 25 countries. The agrochemicals division produces a chemical pesticide, known internally as ‘ALF’, to control pests in a crop which is of worldwide significance, economically and for food production. Pesticides such as ALF only remain effective for a limited time, after which pests become resistant to them and a replacement product needs to be found. A scientific study has shown that the current variant, ALF6, is becoming ineffective in controlling pests and in some places, it has accumulated in the soil to levels which may significantly reduce crop yields in the future if it is continued to be used. The agrochemicals division is evaluating three new products to find one replacement for ALF6.
ALF7
ALF7 is produced by a small chemical modification to the existing product and requires little research and development (R&D) resources to develop it. As it is closely related to the current variant, it is only expected to remain effective, and in use, for three years. It is unclear whether ALF7 will accumulate in the soil in the same way as ALF6 does.
Red
Red is a new type of pesticide which will incur large amounts of R&D expenditure to develop a commercial version. In addition, the agrochemicals division will have to fund a long-term scientific study into the effect of Red on the environment at a cost of $4m for each of the 15 years that the product will be in use, and for five years afterwards.
Production of Red generates large amounts of toxic by-products which must be treated in the division’s waste treatment facility. The production plant used to produce Red must also be decommissioned for cleaning, at an estimated cost of $45m, at the end of the life of the product.
Green
Green is a form of a naturally occurring chemical, thought to be safe and not to accumulate in the environment. It is expected to remain in use for eight years. Production of Green requires relatively large amounts of energy. Significant R&D expenditure is also needed to produce an effective version, as Green remains active in the environment for only a short time. Because of this, Green is unsuitable for use in climates where crop production is already difficult.
The Global Food Production Organisation (GFPO) is a non-governmental organisation which funds new ways to increase global crop production, especially in regions where food for human consumption is already scarce. The GFPO has agreed to make a significant contribution to the R&D costs of producing a replacement for ALF6, but will be unwilling to contribute to the R&D costs for Green because it cannot be used in every region. Similarly, a number of governments, in countries where Alflonnso has licences to operate its other chemical businesses, have warned the company of the potential public disapproval should the agrochemical division choose to replace ALF6 with a product unsuitable for use in areas where food production is scarce.
The newly appointed chief financial officer (CFO) for the agrochemicals division has asked you as a performance management consultant for your advice. ‘One of our analysts in the agrochemicals division’, she said, ‘has produced a single period statement of profit or loss (Appendix 1) to show the profitability of the three new products we are considering as replacements for ALF6.’
‘I think the analyst’s calculations are too simplistic’, she continued. ‘The costs of the waste treatment are apportioned based on the expected revenue of the new products. This is consistent with Alflonnso’s traditional group accounting policy, but I don’t think this gives an accurate costing for the new products. Also, I watched a presentation recently about the use of lifecycle costing and also how environmental management accounting (EMA) can help reduce costs in the categories of conventional, contingent and reputation costs and as a result improve performance.’
(i) Explain how activity based costing may help the agrochemicals division in assessing the profitability of the three new products. (5 marks)
(ii) Using activity based costing, and excluding the value of the grant from the GFPO, calculate the total R&D costs and waste treatment costs of the three new products. (3 marks)
(i) Activity based costing
Activity based costing (ABC) allocates costs to products based on the activities which actually drive the cost to better allocate the costs.
At Alflonnso, the group accounting policy is to allocate waste treatment overhead costs on the basis of revenue, which is arbitrary. From the analyst’s calculations, R&D costs do not seem to be allocated to specific product costs at all. This may be appropriate elsewhere in the group, where different products may consume similar levels of overheads, but the three new products being evaluated consume quite different amounts of R&D and waste treatment overheads.
It is therefore inappropriate to charge these costs to the products on the basis of revenue. Charging these costs on the basis of the activities which drive them, which are research hours and volume of waste by-products for R&D costs and waste treatment costs respectively, will give a more accurate costing. This will provide a better basis on which to evaluate the new products and set appropriate prices.
(ii) Calculation of waste treatment cost
Using your answers from part (a) (ii), calculate the average net profit per litre of each of the three alternative new products over their expected lifecycles and comment on the results.
Average unit cost of each product over total lifecycle
Advise how environmental management accounting (EMA) may help improve the performance of the agrochemicals division.
EMA
Environmental management accounting (EMA) involves the production of non-financial and financial information to support internal environmental management processes. This could involve measuring the physical movements of inputs to a production process, such as materials and energy, and outputs such as waste.
The agrochemicals division could also record financial data on costs and savings related to the environment. It appears that, in common with most other businesses, these costs are not currently identified by Alflonnso’s accounting system and they lie hidden within overheads.
Managers have no incentive to reduce these environment related costs as they are not even aware of them, or the costs of poor environmental practices. EMA allows an organisation to identify environment related costs and take steps to control them. Such costs are often categorised into conventional costs, contingent costs and reputation costs.
Conventional costs
These costs include the cost of energy and raw materials, and may remain hidden within overheads. The energy costs of the three new products in the analyst’s income statement are simply combined with raw material and direct labour costs. This does not, for example, highlight the relatively high energy cost to produce Green. Being unaware of this cost, managers are unable to take steps to redesign the specification or production process for the product in order to reduce the cost.
Contingent costs
These are costs which are incurred in the future, for example, the decommissioning costs of plant used to manufacture Red. This cost is significant at an estimated $45m, but occurs 15 years in the future and so the estimation is unlikely to be accurate.
Identification of these contingent costs will at least allow the agrochemicals division to more accurately estimate the cost of each of the three new products. Also, by identifying these costs at an early stage, this may allow managers to redesign the specification or production process for the product in order to reduce the cost and help prevent managers from focusing only on short-term performance.
Reputation costs
Reputation costs are incurred where an organisation acts in a way which may cause harm to the environment, and include sales lost as a result of loss of reputation. These costs are hard to quantify. For example, the accumulation of the existing product, ALF6, in the soil is said to have a potential effect on crop yields which may lead to future claims from users of the product or to loss of sales due to its potential harm to the environment.
Similarly, Alflonnso’s failure, by producing Green, to improve crop yields in countries where food production is already scarce is likely to arouse disapproval by public and governments in the 25 countries where it operates. This again may result in lost sales or refusal by governments to grant licences for Alflonnso to operate.
Making managers aware of these reputation costs should focus their attention on the need to manage the risks of them occurring.