Question

Question 1: Cost allocation

	Product A	Product B	Total
sales volume (units)	270	150	420
Revenue	$6,000	$36,000	$42,000
Variable costs:
direct materials	$1,200	$2,400	$3,600
direct labor	$2,400	$6,000	$8,400
Contribution margin	$2,400	$27,600	$30,000
Fixed costs			$25,200
Profit			$4,800

a) Allocate the fixed costs between products A and B. Use direct labor dollars as the cost driver.
allocation rate=$  per DL$
allocated costs for A=$  
allocated costs for B=$  

b) Compute the profit margins for products A and B:
profit margin for A=$  
profit margin for B=$  
Enter negative numbers with a minus sign, i.e., a loss of $1,000 should be entered as -1000, not as (1000) or ($1000).

c) Should you drop product A or product B in the short term? Why?

Keep both products -- both have positive contribution marginDrop product A -- it has negative profit margin     Drop product A -- it has negative contribution marginDrop product A -- it has smaller contribution margin than product B

Should you drop product A or product B in the long term? Why?

Keep both products -- both have positive contribution marginDrop product A -- it has negative profit margin     Drop product A -- it has negative contribution marginDrop product A -- it has smaller contribution margin than product B

d) If you drop product A in the short term,
    fixed costs will: remain the same decrease by $7,200

    profit will: decrease by $2,400 increase by $4,800


If you drop product A in the long term,
    fixed costs will: remain the same decrease by $7,200

    profit will: decrease by $2,400 increase by $4,800


e) Allocate the fixed costs between products A and B, using the number of units as the cost driver.
allocation rate=$  per unit
allocated costs for A=$  
allocated costs for B=$  
These allocated amounts are very different from what you got in part (a). In general, should we use the allocated costs from part (a) or from part (e)? Why?

use the allocated costs from (a) -- direct labor is always a better cost driver than the number of unitsuse the allocated costs from (e) -- the number of units is always a better cost driver than direct labor    it depends -- direct labor can be a better cost driver in some situations, and the number of units (or some other activity measure) can be a better cost driver in other situations

f) Suppose that a firm uses a labor-intensive production process. The most reasonable cost driver for manufacturing overhead costs is:

number of unitsmachine hours    direct labor (measured in hours or dollars)

Suppose that a firm uses a machine-intensive production process. The most reasonable cost driver for manufacturing overhead costs is:

number of unitsmachine hours    direct labor (measured in hours or dollars)

g) Suppose that a firm uses a machine-intensive process to make the components for the finished product and then uses a labor-intensive process to assemble the finished product. The firm wants to implement a refined cost allocation with two cost pools:
Pool 1: overhead costs related to the production of components (e.g., machine depreciation, rent for the factory building used to make the components, salaries of machine maintenance staff)
Pool 2: overhead costs related to the assembly of the finished product (e.g., depreciation on tools used by assembly workers, rent for the factory building used for assembly, salaries of labor supervisors)
The most reasonable cost drivers for the two pools are:

direct labor hours or dollars for both poolsmachine hours for both pools    machine-hours for pool 1 and direct labor hours or dollars for pool 2number of units for pool 1 and number of workers for pool 2

Answer 1

a) Allocate the fixed costs between products A and B. Use direct labor dollars as the cost driver.

Fixed cost allocation based on direct labor dollars;

allocation rate= $ 25,200 / 8,400 = $ 3 per DL$
For Product A = 2,400 * 3 = $ 7,200

For Product B = 6,000 * 3 = $ 18,000

b) Compute the profit margins for products A and B:

	Product A	Product B	Total
sales volume (units)	270	150	420
Revenue	$6,000	$36,000	$          42,000
Variable costs:
direct materials	$1,200	$2,400	$            3,600
direct labor	$2,400	$6,000	$            8,400
Contribution margin	$2,400	$27,600	$          30,000
Fixed costs	$7,200	$18,000	$          25,200
Profit	$ -4,800	$9,600	$            4,800

profit margin for A= $ -4,800
profit margin for B= $ 9,600

c) Should you drop product A or product B in the short term? Why?

Keep both products -- both have positive contribution margin

As both the products have positive contribution so it is better to continue with both as positive contribution will help cover up fixed cost and will ultimately result in higher profits

Should you drop product A or product B in the long term? Why?

Keep both products -- both have positive contribution margin

For long term also the justification will remain same.

d) If you drop product A in the short term,

profit will: decrease by $2,400

If product A is dropped then its contribution margin of $ 2,400 is lost, fixed cost will remain same as this cost will not change because of dropping of any product. The scenario of profit will be as under:

	Product B
sales volume (units)	150
Revenue	$36,000
Variable costs:
direct materials	$2,400
direct labor	$6,000
Contribution margin	$27,600
Fixed costs	$25,200
Profit	$2,400

When Product A is continued , profit is $ 4,800 and when Product A is dropped profit will be $ 2,400 so profit will decrease by $2,400

If you drop product A in the long term,
profit will: decrease by $2,400

Justification will be same as of short term

e) Allocate the fixed costs between products A and B, using the number of units as the cost driver.

allocation rate= $ 25,200 / 420 = $ 60 per unit

allocated costs for A= 270 * 60 = $ 16,200
allocated costs for B= 150 * 60 = $ 9,000

These allocated amounts are very different from what you got in part (a). In general, should we use the allocated costs from part (a) or from part (e)? Why?

it depends -- direct labor can be a better cost driver in some situations, and the number of units (or some other activity measure) can be a better cost driver in other situations

If it is a labor intensive industry then direct labor dollar will be a good cost driver

If the time taken to produce the unit is more important then number of units will be a good cost driver

Cost driver depends on the most important factor of production

f) Suppose that a firm uses a labor-intensive production process. The most reasonable cost driver for manufacturing overhead costs is:

direct labor (measured in hours or dollars)

If the firm uses labor-intensive production process then labor is the important factor for production so direct labor hours or dollars will be a reasonable cost driver for manufacturing overhead costs

Suppose that a firm uses a machine-intensive production process. The most reasonable cost driver for manufacturing overhead costs is:

machine hours

If the firm uses machine-intensive production process then machinery is the important factor for production so machine hours will be a reasonable cost driver for manufacturing overhead costs

g) Suppose that a firm uses a machine-intensive process to make the components for the finished product and then uses a labor-intensive process to assemble the finished product. The firm wants to implement a refined cost allocation with two cost pools:
Pool 1: overhead costs related to the production of components (e.g., machine depreciation, rent for the factory building used to make the components, salaries of machine maintenance staff)
Pool 2: overhead costs related to the assembly of the finished product (e.g., depreciation on tools used by assembly workers, rent for the factory building used for assembly, salaries of labor supervisors)
The most reasonable cost drivers for the two pools are:

machine-hours for pool 1 and direct labor hours or dollars for pool 2

Since Pool-1 is machinery driven so machine hours will be a reasonable cost driver and Pool-2 is labor driven so direct labor hours or dollars will be a reasonable cost driver