Question

Scenario

Cartech Manufacturing is engaged in the production of replacement parts for automobiles. One plant specializes in the production of two parts: Part 271 and Part 342. Part 271 produces the highest volume of activity, and for many years it was the only part produced by the plant. Five years ago, Part 342 was added. Part 342 was more difficult to manufacture and required special tooling and setups. Profits increased for the first three years after the addition of the new product. In the past two years, however, the plant has faced intense competition, and its sales of Part 271 have dropped. In fact, the plant showed a small loss in the most recent reporting period. Much of the competition was from foreign sources, and the plant manager was convinced that the foreign producers were guilty of selling the part below the cost of producing it. The following conversation between Tricia Goodson, plant manager, and Jackson Fielding divisional marketing manager, reflects the concerns of the division about the future of the plant and its products.

Jackson: You know, Tricia, the divisional manager is really concerned about the plant’s trend. He indicated that in this budgetary environment, we can’t afford to carry plants that don’t show a profit. We shut one down just last month because it couldn’t handle the competition.

Tricia: Joe, you and I both know that Part 271 has a reputation for quality and value. It has been a mainstay for years. I don’t understand what’s happening.

Jackson: I just received a call from one of our major customers concerning Part 271. He said that a sales representative from another firm offered the part at $20 per unit-- $11 less than what we charge. It’s hard to compete with a price like that. Perhaps the plant is simply obsolete.

Tricia: No. I don’t buy that. From my sources, I know we have good technology. We are efficient. And it’s costing a little more than $21 to produce that part. I don’t see how these companies can afford to sell it so cheaply. I’m not convinced that we should meet the price. Perhaps a better strategy is to emphasize producing and selling more of Part 342. Our margin is high on this product, and we have virtually no competition for it.

Jackson: You may be right. I think we can increase the price significantly and not lose business. I called a few customers to see how they would react to a 25 percent increase in price, and they all said that they would still purchase the same quantity as before.

Tricia: It sounds promising. However, before we make a major commitment to Part 342, I think we had better explore other possible explanations. I want to know how our production costs compare with those of our competitors. Perhaps we could be more efficient and find a way to earn our normal return on Part 271. The market is so much bigger for this part. I’m not sure we can survive with only Part 342. Besides, my production people hate that part. It’s very difficult to produce.

After her meeting with Jackson, Tricia requested an investigation of the production costs and comparative efficiency. She received approval to hire Wake Consulting Group to make an independent investigation.

You, as the staff accountant for Wake Consulting Group, have uncovered the following costs and activities associated with the two products.

	Part 271	Part 342
Production	500,000	100,000
Selling Price	$31.86	$24.00
Prime costs per unit	$9.53	$8.26
Number of production runs	100	200
Receiving orders	400	1,000
Machine hours	125,000	60,000
Direct labor hours	250,000	22,500
Engineering hours	5,000	5,000
Material moves	500	400

Overhead is allocated using a plant-wide rage based on direct labor hours.

Preliminary analysis of costs by Wake Consulting Group revealed that similar costs can be categorized into the following cost pools. Setup costs are costs that occur each time a new production run is made. They involve retooling and reconfiguring the machines and technology. Material handling costs include the equipment and personnel required to transport materials from supplier trucks to the machines. Typically, materials are taken to a storage area before being transported to machines. Each production run will need new materials and materials may also be transported during production runs. Machine costs primarily include depreciation and machine maintenance. Although the machines are depreciated using accelerated depreciation schedules, typically the machine wear out from use and are replaced before they become obsolete. Receiving costs include the costs of clerical and technical help associated with the processing of each order received from a customer. Engineering costs include the technical support staff that implement design changes in the part, manage processes to maintain quality, and provide technical information on the product. The engineering staff maintain a record of the amount of time spent on each product. General plant costs include all the other administrative costs not included in the other cost pools.

Overhead Cost Pools
Setup costs	$240,000
Material handling costs	$900,000
Machine costs	$1,750,000
Receiving costs	$2,100,000
Engineering costs	$1,500,000
General plant costs	$500,000
	TOTAL : $6,990,000 Part 3: Compute overhead and gross margin using Activity-based costing. Per unit Part 271 Part 342 Selling Price $ $ Product Cost Prime costs $ $ Overhead $ $ Total Product Cost $ $ Total Profit $ $ Part 4: Recommendations – Management wants to see what the result is by increasing the price for Product 342 by 25%. Per unit Part 271 Part 342 Selling Price $ $ Product Cost Prime costs $ $ Overhead $ $ Total Product Cost $ $ Total Profit $ $

Answer 1

Activity cost rate

Activities	Activity overhead (a)	Cost driver (b)	Activity rate (a / b)
Set up	240000	300 production runs	$800 per run
Material handling	900000	900 material moves	$1000 per move
Receiving	2100000	1400 orders	$1500 per order
machine	1750000	185000 machine hours	$9.46 per machine hour
engineering	1500000	10000 engineering hours	$150 per engineering hour
General plant	500000	272500 direct labor hours	$1.83 per direct labor

Allocation of overhead costs

Activities	Part 271	Part 342
Set up costs (800*100); (800*200)	80000	160000
Material handling costs (1000*500); (1000*400)	500000	400000
Receiving costs (1500*400); (1500*1000)	600000	1500000
Machine costs (9.46*125000); (9.46*60000)	1182500	567600
Engineering costs (5000*150); (5000*150)	750000	750000
General plant (1.83*250000); (1.83*22500)	457500	41175
Total	$3570000	$3418775

Overhead cost per unit

	Part 271	Part 342
Total overhead costs (a)	3570000	3418775
Units produced (b)	500000	100000
Overhead cost per unit (a/b)	$7.14	$34.19

Therefore,

Part 3

Per unit	Part 271	Part 342
Selling price	31.86	24
Product cost
Prime costs	9.53	8.26
overhead	7.14	34.19
Total product costs	16.67	42.45
Total profit	$15.19	$(18.45)

Part 4

Per unit	Part 271	Part 342
Selling price	31.86	30 (24*1.25)
Product cost
Prime costs	9.53	8.26
overhead	7.14	34.19
Total product costs	16.67	42.45
Total profit	$15.19	$(12.45)