Question

SmartAuto Manufacturing is engaged in the production of replacement parts for automobiles. One plant specializes in the production of two parts: Part #127 and Part #234. Part #127 produced the highest volume of activity, and for many years it was the only part produced by the plant. Five years ago, Part #234 was added. Part #234 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 last two years, however, the plant faced intense competition, and its sales of Part #127 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 Patricia Wang, plant manager, and James Tin, divisional marketing manager, reflects the concerns of the division about the future of the plant and its products.

JAMES:           You know, Patricia, the divisional manager is real 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.

PATRICIA:      James, you and I both know that Part #127 has a reputation for quality and value. It has been a mainstay for years. I don't understand what's happening.

JAMES:           I just received a call from one of our major customers concerning Part #127. 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.

PATRICIA:      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 #234. Our margin is high on this product, and we have virtually no competition for it.

JAMES:           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.

PATRICIA:      It sounds promising. However, before we make a major commitment to Part #234, I think we had better explore other possible explanations. I want to know how our production costs compare to those of our competitors. Perhaps we could be more efficient and find a way to earn our normal return on Part #127. The market is so much bigger for this part. I'm not sure we can survive with only Part #234. Besides, my production people hate that part. It's very difficult to produce.

After her meeting with James, Patricia requested an investigation of the production costs and comparative efficiency. She received approval to hire a consulting group to make an independent investigation. After a three-month assessment, the consulting group provided the following information on the plant's production activities and costs associated with the two products:

	Part #127	Part #234
Production	500,000	100,000
Selling price	$31.86	$24.00
Prime cost 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

* Calculated using a plantwide rate based on direct labor hours. This is the current way of assigning the plant's overhead to its products.

The consulting group recommended switching the overhead assignment to an activity-based approach. It maintained that activity-based cost assignment is more accurate and will provide better information for decision making. To facilitate this recommendation, it grouped the plant's activities into homogeneous sets with the following costs:

Overhead:
	Setup costs	$    240,000
	Machine costs	1,750,000
	Receiving costs	2,100,000
	Engineering costs	2,000,000
	Materials-handling costs	900,000
Total		$ 6,990,000

Part 1: Compute overhead and gross margin using traditional costing.
Part 2: Select the best cost driver and compute overhead rates for each cost pool.
Part 3: Compute overhead and gross margin using Activity-based costing.
Part 4: Increase in price for Product 234 by 25%.
Part 5: Two reasonable recommendation to improve profitability (Explain)

Answer 1

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Part 1: Compute overhead and gross margin using traditional costing:
	Total	Part#127	Part#234
Direct Labor Hours (D)	272,500.00	250,000.00	22,500.00
Manufacturing overhead (A)	6,990,000.00
Manufacturing overhead per direct labor hour (C=A/D)	25.65
Allocated Manufacturing overhead (E=C*D)	6,990,000.00	6,412,844.04	577,155.96
	Part#127	Part#234	Total
Selling Price (B)	31.86	24.00
No. of units sold (F)	500,000.00	100,000.00	600,000.00
Sales (G=B*F)	15,930,000.00	2,400,000.00	18,330,000.00
Prime cost (9.53, 8.26 * F)	4,765,000.00	826,000.00	5,591,000.00
Manufacturing overhead	6,412,844.04	577,155.96	6,990,000.00
Gross Margin (H)	4,752,155.96	996,844.04	5,749,000.00
Product Margin (I=H/F)	9.50	9.97

Part 2 and Part 3	J	K	L=J+K		M	N=M/L	O=N*J	P=N*K	Q=O+P
Calculation of product margin under ABC costing:							Overhead Allocation
Activities	Part#127	Part#234	Total Activity	Overhead	Overhead cost	Activity Rate	Part#127	Part#234	Total
Number of production runs	100.00	200.00	300.00	Setup costs	240,000.00	800.00	80,000.00	160,000.00	240,000.00
Machine hours	125,000.00	60,000.00	185,000.00	Machine costs	1,750,000.00	9.46	1,182,432.43	567,567.57	1,750,000.00
Receiving orders	400.00	1,000.00	1,400.00	Receiving costs	2,100,000.00	1,500.00	600,000.00	1,500,000.00	2,100,000.00
Engineering hours	5,000.00	5,000.00	10,000.00	Engineering costs	2,000,000.00	200.00	1,000,000.00	1,000,000.00	2,000,000.00
Material moves	500.00	400.00	900.00	Materials-handling costs	900,000.00	1,000.00	500,000.00	400,000.00	900,000.00
				Total Overhead	6,990,000.00		3,362,432.43	3,627,567.57	6,990,000.00
Part 4: Increase in price for Product 234 by 25%.				Prime cost (9.53, 8.26 * F)			4,765,000.00	826,000.00	5,591,000.00
Sell Price per unit	24.00	B		Total Cost			8,127,432.43	4,453,567.57	12,581,000.00
Increase by 25%	6.00	U=B*25%		Sales			15,930,000.00	2,400,000.00	18,330,000.00
No. of units sold	100,000.00	F		Margin (S)			7,802,567.57	(2,053,567.57)	5,749,000.00
Increase in profit	600,000.00	V=U*F		Product Margin (T=S/F)			15.61	(20.54)
Current Margin	(2,053,567.57)	S		So we can see that the differences are remarkable. Under traditional costing Part#234 looks like a profitable product but under ABC its generating net loss.
Revised Margin	(1,453,567.57)	W=S+V
Even after increasing the sell price Part#234 is still in loss.

Part 5: Two reasonable recommendation to improve profitability (Explain)

Company should improve the production run. For 100,000 units production is high as compared to Part#127.

Company should increase the sell price. Judging by the cost incurred product is selling at a very low sell price.