The Company

MSM produces and distributes mid-priced, high quality blankets for the US market. MSM sells three
branded line (Ashmont, Velona and Fairfax) and a private label line. Private label was typically more than
half of commercial sector sales. Some basic information on their product line for 2004 shown below:
(TABEL)
MSM sold its blankets to 10 bedding products distributors (for resale to small retailers) and to several
large chains which bought blankets direct from the factory (in large orders), to avoid middleman.
Before 2004, MSM had never supplied blankets to the US government, instead focusing totally on the
commercial market.
A blanket which MSM sold to a distributor for $35 would typically sell at about $60 in a retail store,
allowing 15% gross margin for the distributor, 30% for the retailer and $5 freight. Discount stores which
bought direct and operated on lower margins could charge as low as $50 for the same blanket.
In early 2003, MSM decided to bid on large Army contract because they were having trouble
consistently selling all of their capacity in the commercial sector. Over a 5 year period, MSM had
operated, on average, at only 85 percent of capacity. The Army bid was a cost-plus contract in which
MSM had no prior experience. They lost the bid to a larger competitor.

THE NAVY CONTRACT
In late 2003, MSM took on a contract to supply 125,00 special-order blankets for the US Navy and
Marine Corps in 2004. The contract was not cost-plus, but MS agreed to allow the Navy to audit their
cost records during 2004 to verify that the price charged the Navy ($37.30 per blanket) reflected a fair
assignment of costs and a fair profit margin.
THE FACTORY
MSM operated out of one factory located in an industrial park in the suburbs of a large Midwestern city.
The building, including all warehouse space and offices, was leased from the owner of the industrial
park. Rent was included in factory overhead.
Blankets were woven from very large spools of thread on semi-automatic looms that MSM had
acquired, second-hand, from large textile mills that were shutting down as more and more production
moved overseas. There was no shortage of available, well-maintained used textile weaving equipment in
the US. MSMs blankets used varying proportions of cotton, wool and synthetic (darcon or
polypropylene) thread to achieve the look and feel that its customers wanted in high-quality bedding, at
very reasonable prices.
MSM owned and operated 13 weaving looms. Full capacity operation for each loom was about 20 eight-
hour shifts per week for about 50 week per years=. Maintenance and repair work consumed the
remaining time. Management estimated that each loom could be operated for 7,840 hours per year.
Any of the products could be produced on any of the looms. Throughtput rates per machine varied
across the 5 product line as follows:
(TABEL)
The variation in throughput was caused by different run speeds for different mixes of thread and
different end product densities. In general, the more dense the weave of the blanket and the more
expensive the thread, the lower the weaving speed.
MSM paid high wages for its community, $15 to $20 per hour, plus good benefits, the total was about
$40,000 per worker per year, excluding benefits. Each loom operator was paid for 2080 hours and
worked only 1920 hours. The wage system included incentive bonuses for productivity, this pay package
allowed MSM to keep labor cost per blanket very low, in spite of paying good wages and benefits.
MSM was one of a relatively few profitable US textile converters because of its very lean operating
philosophy. Labor productivity was as high as in any textile converter in the country, MSMs 53 loom
operators broke down to only 2 or 3 persons per shift, depending on product mix. Each o]operator took
care of several looms. Using used equipment kept the capital investment very low (only about $6.4
million for the looms and related support equipment). The company pushed hard on the made in
America theme on keep its sales volume high.
MSMs accounting system
Manufacturing cost. MSM used a standard cost system for production. All spending variances were
charged directly to factory overhead. Standard cost allowed for normal scrap and waste and labor
inefficiency, but these amount were very low at MSM. Raw material cost were charge to products at
actual prices paid for the mix of thread in the specific product line. Factory labor was assigned to
product based on the average labor time per blanket, taking into account some small variations in labor
time across the five product line. Fringe benefit were charge to factory overhead.
Factory overhead was fixed across a very wide range of product. Planned total factory overhead cost
was divided by planned total production to yield standard overhead cost per blanket. The number for
2004 was $3.95 per blanket. Costing excess capacity was not an issue in 2004 because the factory was
projected to run at full capacity.
(TABEL)
Selling, Marketing and Administrative (SM&A) cost. For purposes of estimating total cost for use in
setting planned selling prices, MSM charge SM&A cost to product in 2004 at a rate of $96. Per unit.
This was about 1/3 selling, 1/3 marketing ,and 1/3 administration. A unit was a technical term for a
unit of capacity equal to one loom running for one shift. With 13 looms in the factory, each operating
980 shift per year, annual factory capacity was equal to 12,740 unit (13x980). The idea was to charge
SM&A to product based on the amount of capacity devoted to each blanket. Since SM&A cost was not
volume-dependent, the cost per unit depended heavily on the number of unit in the denominator
MSM chose to assign SM&A to product on the assumption that would equal 85% of capacity. This
number was set based on average capacity over the past five years. Using the 85% assumption, MSM
would ever absorb SM&A cost in a good year, like 2004, when the business operated at full capacity.
Standard Selling Prices. MSM calculated the sales price it wanted per blanket. By adding planned profit
at $240. Per unit to total cost (COGS plus SM&A). The profit rate of $240. Per unit was set to produce a
good return on asset employed when SMS operated close to capacity. Using this account system,
planned selling prices for the five product line for 2004 are shown below:
(TABEL)
In a year like 2004 when demand was very strong, MSM was able to charge planned prices to all its
customers and still sell out the factory. When demand was not so string, prices usually had to reduced in
line with the sales managers knowledge of competitive market conditions. The Navy price of $37.30 per
blanket was set based on the system described above. Because the price seemed generally reasonable
for the quality and size (90x66) specified in the contract, it was tentatively accepted by the Navy. A final
determination of price, per the contract was dependent on a Navy audit of MSMs cost records,
according to federal Cost Accounting Standards.
The Navy Audit
MSM had no experience with federal audits and had no idea how the Naxy would evaluate the price of
$37,30. Management assumed they would have no trouble surviving the audit because the price
charged to the Navy was based on the same system they used to set all prices. Management knew the
business was not earning abnormally high profits on any of its blankets. Their plan was to wait for the
Navy audit to see what accounting methods they should use, and the adopt them right away for navy
order.
The situation started to go downhill quickly when the auditors first reaction was to ask why the Navy
was being charged 118% of average non-manufacturing cost per blanket (1.80/1.53) and 116% of
average profit per blanket (4.45/3.82). on its face, he said, the Navy price was blatantly unfair.
The two owners looked at each other in silence. Neither Doug San Miguel nor Joe Moses had any
knowledge of accounting systems. Moses handled sales and San Miguel ran the factory. They had always
assumed accountants were all trained about the same and that they knew how to count the beans. All
at once it dawned on them that if they wanted to keep the Navy business and avoid a federal law suit.
They were in dire need of a crash course in product costing.