My client is a second-hand clothes retailer. The business consists of selling clothes, which the Company purchases from suppliers, who are recycling factories in Europe. These recycling factories collect second-hand clothes from individuals and then sell them in bulk packages to our client and other companies like it. The purchase price of a bulk sold by the supplier is based on the weight of the bulk.
The Company sells only online via the Company’s website. The Company does not have any physical stores.
When new delivery is received by the Company it goes through the following process:
- Sorting of clothes – This is a manual process during which employees of the Company sort out the delivered goods in two- those that are accepted and will be further process and those that are not accepted, will be marked as “waste” and sold to recycle firms. As per the Company’s internal policy for sorting, the Company accepts only clothes of high quality, i.e. no knock-outs (i.e. fake Louis Vuitton, Channel, etc.), no damaged goods (i.e. no clothes with holes in them, or iron burns, or cigarette burns, ets.);
- Ironing and disinfection of goods- this a partly manual, partly automated process as the clothes there are employees who operate the disinfection and ironing machines and load and unload the clothes in and out of the machines;
- Writing descriptions of accepted goods – This is a manual process, where several employees write a detailed description of each approved piece of clothing and generate a unique code under which the good is included in the inventory master files and the website. The detailed description is published on the website.
- Taking photos – This is a manual process, where employees take high quality pictures of clothes, which are then uploaded on the Company’s website. Each piece of clothing is photographed individually and the photo is used only for the purpose of the sale of this specific piece together with the detailed description of the item. If an item is sold, the item is removed from the website and its photo is no longer useful, as generally there are no other such items (this is a second-hand store).
- Packaging – This is an automated process where each good is packaged into a plastic vacuum bag in order to be stored and ready for shipment upon sale.
Currently the Company applies a traditional absorption costing model for allocation of overheads for its business. The Company considers the following costs as overheads: labor of employees involved in the above 5 processes, depreciation of assets used in the above 5 processes (e.g. buildings where these processes take place, disinfection machines, ironing machines, cameras, etc.), electricity, transport and raw materials used in the processing of clothes. At the moment when one item is processed and prepared for sale, the Company allocates to it a portion of the total overheads incurred for the period in which it has been processed. The absorption rate used to calculate how much from total overheads to be allocated to each item is equal to:
Weight of the item / Total weight of processed items
The Company chose this absorption rate because its initial cost, i.e. the purchase price of the goods, is based on their weight (the Company buys a bulk of clothes from the suppliers and pays at a price of XX euro/kg).
The Company uses the simplest method of dealing with overheads under which it assumes all overheads can be treated together and a single overhead absorption rate is applied to all of them. However, given that the Company processes multiple products the conventional way of treating overheads using an over-simplified base is not good enough.
- Please advise whether you would use another costing method for this business and why or why not?
- Do you find the currently used absorption rate appropriate? Would you use a different one and why? How would you derive it?