Question

St. Louis Machining Company is engaged in the production
of machine parts. One division specializes in the
production of two machine parts: Part #123 and Part #456.
Historically, the profitability of the division has been
tied to Part #123. However, in the past two years, the
division has been facing intense competition and the
sales of this part have declined. The following
conversation between Betty DeRose, division manager,
and Sandy Beach, marketing manager, reflects the
concerns of the division's top management:

Sandy:  I just received a call from a customer about
        Part #123. He said that a sales rep from another
        firm had offered the part at $20.00 per part.
        That is $12.00 less than what we ask!

Betty:  It's costing us about $21.00 to manufacture 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. Maybe a better strategy
        is to emphasize producing and selling more of
        Part #456. Our margin is high on this product
        and we have virtually no competition for it.

Sandy:  You may be right. Our recent market research
        indicates that we could increase the price by
        80% without losing any unit sales.

Betty:  Before we make a major commitment to Part #456;
        however, I think we should explore other possible
        explanations. I want to know how our manufacturing
        costs compare to those of our competitors. Perhaps
        we could be more efficient and find a way to earn
        more on Part #123.

After her meeting with Sandy, Betty requested and received
from the chief accountant the following information on the
division's manufacturing activities and costs associated
with the two products:

                                 Part #123       Part #456
Sales in units                    200,000         40,000
Selling price per unit            $32.00          $24.00
Direct material cost per unit     $ 3.50          $ 3.80
Direct labor cost per unit        $ 5.00          $ 2.50
Overhead cost per unit            $12.71          $ 6.35
Number of setups                     40              80  
Number of orders                    180             320
Machine hours                     50,000          20,000
Direct labor hours               100,000          10,000
Engineering hours                  2,000           2,000
Number of material moves            220             180

Upon examining the above data, Betty decided that she wanted
to know more about the overhead costs, since they were such
a high proportion of total manufacturing costs. Betty was
told the existing cost accounting system allocated overhead
costs to products on the basis of direct labor hours. 

After reading an article about the potential benefits of
adopting an activity based costing system, Betty requested
and received the following information on overhead costs
and activities:

Activity               Expected cost     Activity driver
Machine setup            $ 96,000        120 setups
Machine depreciation     $700,000        70,000 machine hours
Orders                   $800,000        500 orders
Engineering              $840,000        4,000 engineering hours
Material handling        $360,000        400 material moves

Calculate the gross profit per unit for Part #123 using
activity based costing. For this question assume all
units produced are sold and ignore the overhead variance.

Calculate the gross profit per unit for Part #456 using
activity based costing. For this question assume all
units produced are sold and ignore the overhead variance.

Answer 1

Activity	Amount	Activity	Driver	Activity	Cost
Machine Setup	$            96,000	120	setups	$          800	per setuup
Machine Depreciation	$ 700,000	70,000	machine hours	$            10	per machine hour
Orders	$ 800,000	500	Orders	$ 1,600	per order
Engineering	$ 840,000	4,000	Engineering Hours	$          210	per engineering hour
Material Handling	$ 360,000	400	Material Moves	$          900	per material move
	$       2,796,000

	Part #123	Part #456
Overhead Cost
Machine Setup	$                        32,000	$                     64,000
Machine Depreciation	$ 500,000	$ 200,000
Orders	$ 288,000	$ 512,000
Engineering	$ 420,000	$ 420,000
Material Handling	$ 198,000	$ 162,000
Total Overhead Cost	$                   1,438,000	$ 1,358,000
Number of Units	200,000	40,000
Overhead Cost per Unit	$                            7.19	$                       33.95

	Part #123	Part #456
Selling Price per unit	$                          32.00	$                       24.00
Less: Cost of goods sold
Direct Material Cost per unit	$                            3.50	$                         3.80
Direct Labor Cost per unit	$                            5.00	$                         2.50
Overhead Cost per unit	$                            7.19	$                       33.95
Gross Profit per Unit	$                          16.31	$ -16.25