5-54 West Chemical Company produces three products. pr oducts. The firm sets the target price of each product at 150% of the product's total manufacturing cost. Recognizing that the firm was able to sell Product C at a much higher price than the target price of the product and lost money on Product B, To Watson, CEO, wants to promote Product C much more aggressively and phase out Product Prod uct B. He believes that the information suggests that Product C has the greatest potential among the firm's three products since the actual selling price of Product C was almost 50 percent higher than the target price while the firm was forced to sell Product B at a price below the target price. Both the budgeted and actual factory overhead for 2010 are $493,000. The actual units sold for each product also are the same as the budgeted units. The firm uses direct labor dollars d ollars to estimate manufacturing overhead costs. The direct materials materials and direct labor costs per unit for each product are: Target selling price (% of total mfg. cost) = Budgeted factory overhead = Actual factory overhead incurred =
150% $493,000 $493,000
Actual operating results for 2007 are as follows Product Sales Quantity Target Price A 1,000 $279.00 B 5,000 $294.00 C 500 $199.50
Actual Price $280.00 $250.00 $300.00
Difference $1.00 ($44.00) $100.50
The direct labor and direct d irect materials cost per unit are as follows:
Direct Materials Direct labor Total prime cost
Product A $50.00 $20.00 $70.00
Product B $114.40 $12.00 $126.40
Product C $65.00 $10.00 $75.00
The controller notes that not all of the products consume factory overhead costs similarly. Upon further investigation, she identified the following overhead consumption data for 2007:
Number of setups Weight of direct materials (pounds) Waste and hazardous disposals Quality inspections Utilities (machine hours) TOTAL
Product A 2 400 25 30 2,000
Product B 5 250 45 35 7,000
Product C 3 350 30 35 1,000
Total Overhead $8,000 $100,000 $250,000 $75,000 $60,000 $493,000
Required 1. Determine the manufacturing cost per unit for each of the products using the volume-based method. 2. What is the least profitable and the most profitable product under both the current and the ABC costing systems? 3. What is the new target price for each product based on 150 percent of the new costs under the ABC system? Compare this price with the actual selling price. 4. Comment on the result. As a manager of West Chemical, describe what actions you would take based on the information provided by the activity-based unit costs.
5-58 Superior Door Company (SDC) manufactures and sells two main product lines, exterior doors and interior doors. Its products are sold through industry and wholesale suppliers. SDC is known for their quality and value, and are often priced lower than competing brands. During a recent executive meeting, Jerry Rhodes, the vice president of marketing, made three observations: First, the price of the interior door (ID), a highvolume product for the firm, is often higher than that of competitors’ products. Second, SDC has been struggling to maintain its market share of ID. Third, the firm has sold approximately the same number of units of external doors (ED), a high margin product, despite a 7.5 percent increase in price. Noting that the profit margin p er unit of ED is higher than that of ID, Rhodes has suggested that SDC should push for producing and selling of ED. Regina Jones, the plant manager, objected to this strategy because the manufacturing processes of ED were much more complicated than those for ID. The total manufacturing costs would increase substantially if SDC shifted its product line to emphasize ED. Joseph Higgins, the vice president of finance, observes that SDC uses a direct labor cost based system to determine the amount of manufacturing overhead for all of its products. Selected operating data for the year 2010 follow:
Product
ED ID
Units Sold
5,000 50,000
Cost per Unit Direct Direct Materials Labor
$40 $30
Selling Price per Unit $24 $150 $12 $80
Joseph also has collected the following data on activity cost pools and their cost drivers:B101 Cost Pools/Activities Machine operation Support labor overhead Machine setup Assembly Inspection
Cost Drivers Machine-hours Direct labor costs Setup hours Number of operators Inspection hours
Estimated Overhead Costs and Activity Consumption Information
Activity Cost Pool Machine operation Support labor overhead Machine setup Assembly Inspection Total
Activity Consumption Levels Total Overhead Activity ED $200,000 10,000 2,500 $150,800 $720,000 $120,000 $82,500 2,500 1,200 $140,875 402,500 192,500 $66,250 4,000 1,800 $640,425
ID 7,500 $600,000 1,300 210,000 2,200
Joseph explained why these cost drivers were appropriate: • The overhead costs for machine operation had nothing to do with the direct labor-hours. These costs were more likely to vary with the number of machine-hours. • The support labor included allowances for benefits, break periods and costs related to the supervising and engineering staff. This overhead was indirect to the products but was related to the direct labor costs. • The setup overhead was generated by changing the job to be run and should be related to the setup hours rather than the direct labor-hours. • The assembly overheads related to costs incurred to the number of cutting, trimming, and sanding operators. Therefore, the correct cost driver should be the number of operators. • The inspection overhead arose from checking the finished goods. The higher the number of finished units, the higher the inspection overhead costs. The appropriate cost driver should be the number of hours spent on the inspection. Required 1. Using the current costing system, which uses direct labor costs as the basis to determine overhead costs, calculate the unit manufacturing costs of the two products. 2. Using the activity-based costing (ABC) system, calculate the unit manu facturing costs of the two products. 3. Under ABC, is the exterior door line as profitable as the vice-president of marketing thinks it is under the existing costing system? 4. Evaluate the marketing vice-president’s suggestion to shift the sales mix in favor of exterior doors. 5. Give at least two reasons for the difference between the results for the two different costing systems.
Chapter 5
5-54 Volume-based Costing Versus ABC
1.
Product A Product B Product C Materials $50.00 $114.40 $65.00 Labor 20.00 12.00 10.00 Overhead* 116.00 69.60 58.00 Total Cost $186.00 $ 196.00 $133.00 *overhead is applied based on direct labor dollars so the rate is: $5.80/ Direct labor dollar = $493,000/($20x1,000+$12x5,000+$10x500) $116 = 5.8x20; $69.60 = 5.8x12; $58 =5.8x10 2. Current Costing system Actual selling price Product manufacturing cost Gross margin Gross margin ratio
Product A $280 186 $ 94 33.57%
Product B $250 196 $ 54 21.6%
Product C $300 133 $167 55.67%
Based on the current cost data, product B is the least profitable product with a gross margin per unit of $54.00 (21.6%) and product C is the most profitable product with a gross margin per unit of $167.00 (55.67%). Product costs based on the activity-based costing system Product A Product B Product C Direct materials $ 50.00 $114.40 $ 65.00 Direct labor 20.00 12.00 10.00 Factory overhead: Setups (a) 1.60 0.80 4.80 (b) Materials handling 40.00 5.00 70.00 (c) Hazardous control 62.50 22.50 150.00 (d) Quality control 22.50 5.25 52.50 (e) Utilities 12.00 8.40 12.00 Total Factory overhead $138.60 $41.95 $289.30 Total Cost $208.60 $168.35 $364.30 Actual selling price Product manufacturing cost Gross margin Gross margin ratio
$280.00 208.60 $ 71.40 25.50%
1
$250.00 168.35 $ 81.65 32.66%
$300.00 364.30 ($64.30) (21.43)%
Chapter 5
5-54 (continued -1)
Notes: (a) Setups: Cost per setup: $8,000 / (2 + 5 + 3) = $800 per setup Product A = 2 x $800 = $1,600; $1,600 /1,000 = $1.60 per unit Product B = 5 x $800 = $4,000; $4,000 /5,000 = $0.80 per unit Product C = 3 x $800 = $2,400; $2,400 /500 = $4.80 per unit (b) Materials handling: Cost per pound = $100,000 / (400 + 250 + 350) = $100 per pound Product A = 400 x $100 = $40,000; $40,000/1,000 = $40.00 per unit Product B = 250 x $100 = $25,000; $25,000/5,000 = $ 5.00 per unit Product C = 350 x $100 = $35,000; $35,000/500 = $70.00 per unit (c) Waste and hazardous disposals: Cost per disposal: $250,000/(25 + 45 + 30) = $2,500 per disposal Product A = 25 x $2,500 = $ 62,500; $ 62,500/1,000 = $ 62.50/unit Product B = 45 x $2,500 = $112,500; $112,500/5,000 = $ 22.50/unit Product C = 30 x $2,500 = $ 75,000; $ 75,000/500 = $150.00/unit (d) Quality inspections: Cost per inspection = $75,000/(30 + 35 + 35) = $750 per inspection Product A = 30 x $750 = $22,500; $22,500/1,000 = $22.50 per unit Product B = 35 x $750 = $26,250; $26,250/5,000 = $ 5.25 per unit Product C = 35 x $750 = $26,250; $26,250/500 = $52.50 per unit (e) Utilities: Cost per MH = $60,000 / (2,000 + 7,000 + 1,000) = $6.00 per MH Product A = 2,000 x $6 = $12,000; $12,000/1,000 = $12.00 per unit Product B = 7,000 x $6 = $42,000; $42,000/5,000 = $ 8.40 per unit Product C = 1,000 x $6 = $ 6,000; $ 6,000/500 = $12.00 per unit
2
Chapter 5
5-54 (continued-2)
3. Comparison of reported product costs, new target price, actual selling price, and gross margin (loss): Product A Product B Product C Product costs: 1. Direct-labor based system $186.00 $196.00 $133.00 2. Activity-based system $208.60 $168.35 $364.30 ABC-based product costs: Target price (150%) Actual selling price Difference in price
$312.90 $280.00 $32.90
Direct-labor based costing system Gross margin Gross margin ratio
$ 94 33.57%
$ 54 21.6%
$167 55.67%
Activity-based costing system: Gross margin Gross margin ratio
$71.40 25.50%
$81.65 32.66%
$(64.30) (21.43%)
$252.53 $250.00 $ 2.52
$546.45 $300.00 $246.45
4. Strategic and Competitive Analysis 1. Emphasizing Product C as suggested by the current directlabor-cost based overhead costing system is likely to harm the firm’s competitiveness. The activity-based costing system shows that the manufacturing cost of Product C is $364.30 per unit and, at the current selling price, the firm suffers a $64.30 loss for each unit it manufactures and sells. 2. If the actual selling prices of products A & B are fair market prices for these products and a markup of 150% is a common industry practice, the firm needs to examine the manufacturing cost of product A. The fact that the firm’s target price, determined using 150% of the manufacturing cost, is more than 10 percent over the fair market price of the product suggests possible waste and inefficiency in the manufacturing of product A.
3
Chapter 5
5-58 Volume-Based Costing vs. ABC
1. Manufacturing Costs – Volume Based Basic Data
Units Sold
Materials
Labor
Selling Price
Exterior Door Interior Door
5,000 50,000
$40 $30
$24 $12
$150 $80
Activities
Activity Cost Driver
Machine operation Support labor overhead Machine setup Assembly Inspection Total
Total Activity Exterior Door Interior Door
Machine-hours Direct labor costs Setup hours Number of parts Inspection hours
$200,000 $150,800 $82,500 $140,875 $66,250 $640,425
10,000 $ 720,000 2,500 402,500 4,000
$
2,500 120,000 1,200 192,500 1,800
$
7,500 600,000 1,300 210,000 2,200
Using the Volume Based Method
Overhead allocated on the basis of di rect labor cost
$
0.889
=$640,425/$720,000
Total
Exterior Door Interior Door
Per Unit
$ 106,738 533,688
$
21.35 10.67
2. Activity Rates and Costs Using ABC: Using the Activity-based Method Activity Rate
Machine operation Support labor overhead Machine setup Assembly Inspection
$20.0000 $0.2094 $33.0000 $0.3500 $16.5625
Activity Cost Driver
Machine-hours Direct labor costs Setup hours Number of parts Inspection hours
Exterior Door Activities Overhead
2,500 120,000 1,200 192,500 1,800
4
$50,000 $25,133 $39,600 $67,375 $29,813 $211,921
Interior Door Activities Overhead
7,500 600,000 1,300 210,000 2,200
$150,000 $125,667 $42,900 $73,500 $36,438 $428,504
Chapter 5
5-58 (continued-1) Exterior Door
Number of units Sales Direct materials Direct Labor Overhead Machine Operation Support Labor Machine Setup Assembly Inspection
Total $
Interior Door
Per Unit 5,000 750,000 200,000 120,000
$
150.00 40.00 24.00
Total
50,000.00 25,133.33 39,600.00 67,375.00 29,812.50
Per Unit 50,000 4,000,000 1,500,000 600,000
$
80.00 30.00 12.00
150,000.00 125,666.67 42,900.00 73,500.00 36,437.50
Total Overhead
211,920.83
42.38
Total Manufacturing Costs Gross Margin Gross Margin Percent
531,920.83 $ 218,079.17 $ 29.08%
106.38 43.62
428,504.17
8.57
2,528,504.17 $ 1,471,495.83
50.57 29.43 36.79%
$
3. The above profitability analysis indicates that the Exterior Door is not as profitable as the vice president of marketing thinks it is.
5
Chapter 5
5-58 (continued-2)
4. Unit Cost Comparison of overhead costs between the current and ABC costing systems Cost Comparison of Overhead costs per unit Volume-based Activity Based Difference (ABC-VB)
Ext. Doors
$ $
21.35 42.38 21.04
Int. Doors
$
According to the ABC cost data, a shift to more Exterior Door units and fewer Interior Door units would be ill advised. The apparent higher unit gross margin of the Exterior Doors relative to the Interior Doors indicates that the current costing system distorted relative unit profitability. 5. Among the reasons for the difference are: a. The current direct labor based costing system focused on only one manufacturing activity of the entire production process. It measures only one attribute of the individual product: the number of direct labor hours consumed. By contrast, the ABC system considered all activities of the manufacturing processes. Costs were traced from activities to products based on the product’s demand for these activities during the production process. The allocation bases used in ABC were thus measures of the activities performed. For Superior Door Company, the ABC systems listed not only the unit-level activities (machine operation, support labor overhead) but also the batch-level ones (setup, assembly, and inspection.) b. Under the volume-based costing system, the high-volume interior doors were overcosted and the low-volume exterior doors were undercosted. The source of this distortion is the choice of a single volume-related allocation base, direct labor cost, for tracing of costs from manufacturing to products. Using a volumerelated allocation base alone to trace costs to products distorted reported product costs if some of the product-related activities were not related to volume, such as the setup hours. c. Differences in the complexity of the products also contribute to cost distortion. Using a volume-based costing system, overhead costs differ only when different number of units are manufactured. Although the exterior doors were low-volume products, they actually consume more resources – a result not related to volume.
6
10.67 8.57 (2.10)
