Question

Spokane Inc. produces three products- A-111, B-222 and C-333. While the products have been quite profitable over the past few years and the company operates at full capacity (based on machine hours), there has been increased competitive pressure recently which has caused the company to re-evaluate its products.

The company allocates manufacturing overhead on the basis of direct labour costs. The income statement for the most recent fiscal year is presented in Exhibit 1.

Based on these financial statements, the company is considering reducing production of the A-111 model, and transferring production to the C-333 model. They feel there is a chance to increase market share in that segment. From the profitability statement in Exhibit 1, they feel the C-333 model provides higher margins. The vice president of finance was not convinced this decision was appropriate. He decided to re-evaluate the allocation of overhead costs using activity based costing, before making a final decision on the A-111 model. The review was conducted with the understanding that there was no ability to increase available machine hours, from the current annual level of 28,250 hours, in the immediate future. All selling and administrative expenses are considered to be fixed.  

The vice-president reviewed the major components of overhead (a total of $1,200,000) and determined that the major activities driving the manufacturing overhead costs were:

1. Set-ups
2. Inventory handling
3. Machine operations

With the activities identified the vice-president determined the following unit rates for the activities, based on the information given in Exhibit 2:

Activity	Amount	Unit rate
Set-ups	$180,000	$300.00 per set-up hour
Inventory handling	210,000	$100.00 per material movement
Machine operations	810,000	$30.00 per machine hour

Exhibit 1

Spokane Inc.

Product Profitability Statement

	A-111	B-222	C-333	Total
Sales	$1,300,000	$1,100,000	$500,000	$2,900,000
Material costs	200,000	160,000	40,000	400,000
Direct labour	150,000	120,000	30,000	300,000
Overhead (@400%)	600,000	480,000	120,000	1,200,000
Cost of goods sold	950,000	760,000	190,000	1,900,000
Gross margin	$350,000	$340,000	$310,000	$1,000,000
Gross margin %	26.9%	30.9%	62.0%	34.5%
Volume	40,000	30,000	5,500
Potential Market Demand	45,000	34,000	10,000

Exhibit 2

Spokane Inc.

Production Information

		A-111	B-222	C-333
Sales volume		40,000	30,000	5,500
Production runs		50	30	25
Set-up time per run		2	5	14
Material movements per run		18	15	30
Machine hours per unit		.35	.25	1.0

Required:

1. Based on the above information, prepare a product profitability statement, using an ABC approach.

2. Compare the ABC results with the results provided by “traditional” product profitability statement provided above. Do you agree with the company’s plan to reduce the production of the A-111 and increase production of the C-333 model? What steps would you take to improve overall profitability?

3. The company has the opportunity to manufacture another product. The new product would sell for $29.00. Direct material cost is $6.50 and direct labour would be $4.00 per unit. Annual demand is expected to be 10,000 units. Production would take place in batches of 1,000 units and it would take .4 hours per unit of machine time. Set-up time would be three hours per batch. The number of material movements for this product would be 20 per set-up. Assume the unit rates you have developed in part 1 are valid for this product. Given this information, which products would you recommend Spokane produce?

Answer 1

PLEASE GV A RATING IF U LIKE MY EFFORTS, IT WILL KEEP US MOTIVATED. THANK YOU IN ADVANCE. In case u have a query post in comment column, will revert.

Ans : Activity-based costing (ABC) is a costing method that identifies activities in an organization and assigns the cost of each activity to all products and services according to the actual consumption by each. This model assigns more indirect costs (overhead) into direct costs compared to conventional costing.

Activity-based costing (ABC) is mostly used in the manufacturing industry since it enhances the reliability of cost data, hence producing nearly true costs and better classifying the costs incurred by the company during its production process.

This costing system is used in target costing, product costing, product line profitability analysis, customer profitability analysis, and service pricing. Activity-based costing is used to get a better grasp on costs, allowing companies to form a more appropriate pricing strategy.

The formula for activity-based costing is the cost pool total divided by cost driver, which yields the cost driver rate. The cost driver rate is used in activity-based costing to calculate the amount of overhead and indirect costs related to a particular activity.

The ABC calculation is as follows:

1. Identify all the activities required to create the product.

1. Divide the activities into cost pools, which includes all the individual costs related to an activity—such as manufacturing. Calculate the total overhead of each cost pool.

1. Assign each cost pool activity cost drivers, such as hours or units.

1. Calculate the cost driver rate by dividing the total overhead in each cost pool by the total cost drivers.

1. Divide the total overhead of each cost pool by the total cost drivers to get the cost driver rate.

1. Multiply the cost driver rate by the number of cost drivers.

Activity-based costing (ABC) enhances the costing process in three ways. First, it expands the number of cost pools that can be used to assemble overhead costs. Instead of accumulating all costs in one company-wide pool, it pools costs by activity.

Second, it creates new bases for assigning overhead costs to items such that costs are allocated based on the activities that generate costs instead of on volume measures, such as machine hours or direct labor costs.

Finally, ABC alters the nature of several indirect costs, making costs previously considered indirect—such as depreciation, utilities, or salaries—traceable to certain activities. Alternatively, ABC transfers overhead costs from high-volume products to low-volume products, raising the unit cost of low-volume products.

Ans : 1 ) Product profitability statement, using an ABC approach

	A-111	B-222	C-333	Total
a)Sales	$1,300,000	$1,100,000	$500,000	$2,900,000
Material costs	200,000	160,000	40,000	400,000
Direct labour	150,000	120,000	30,000	300,000
Contribution (sales – DM – DL)	950000	820000	430000	2200000
Overhead Under Abc: ( note 1 )
Set-ups ($300.00 per set-up hour)	30000	45000	105000	180000
Inventory handling($100.00 per material movement) *	90000	45000	75000	210000
Machine operations ($30.00 per machine hour)	420000	225000	165000	810000
b)Cost of goods sold	890,000	595,000	415,000	1,900,000
c)Gross margin ( A-B)	$410,000	$505,000	$85,000	$1,000,000
d)Gross margin % ( c *100 / a)	31.53%	45.91%	17.0%	34.5%

Note 1 :

a) Production runs		50	30	25
b) Set-up time per run		2	5	14
c) Set up hr = a *b		100	150	350
d) Set-ups cost ( per set-up hour)		300	300	300
e) Total set up cost ( c*d)		30000	45000	105000
f) Material movements per run		18	15	30
g) Total Material movements (f *a)		900	450	750
h) Material movements cost( g * $100.00 )		90000	45000	75000
i) Sales volume units		40000	30000	5500
j) Machine hours per unit		0.35	0.25	1.0
k) Total Machine hours ( i * j)		14000	7500	5500
l) Total Machine hours cost ( k * $ 30)		420000	225000	165000

Ans 2) Comparison of profitability statement under ABC and “traditional” method

	A-111	B-222	C-333	Total
a)Gross margin ( ABC)	$410,000	$505,000	$85,000	$1,000,000
b)Gross margin ( Traditional )	$350,000	$340,000	$310,000	$1,000,000
c)Increase in G.P. ( a-b)	60000	165000	(225000)

So , it is very clear that product C-333 is not a profitable unit and on the other hand A-111 is the most profitable . So, the company’s plan to reduce the production of the A-111 and increase production of the C-333 model is to be rejected .

We should try and increase the sale of A-111 and B-222 as much as possible and reduce production of C-333 but not shut it unless we can reduce some overheads.

Ans 3) Profitability of new product   

	$$
a)Sales ( 29 *10000)	290000
Material costs ( 6.5 *10000)	65000
Direct labour ( 4 *10000)	40000
Contribution (sales – DM – DL)	185000
Overhead Under Abc:
Set-ups ($300.00 per set-up hour)	9000
Inventory handling($100.00 per material movement) *	20000
Machine operations ($30.00 per machine hour)	120000
b)Cost of goods sold	254000
c)Gross margin ( A-B)	36000
d)Gross margin % ( c *100 / a)	12.41%

So, we would recommend that the co should start producing This new component and reduce C-333 as much as possible .( transfer machine hrs to produce this new product )

Note 2 )

a) Production runs ( 10000 / 1000 )	10
b) Set-up time per run	3 hrs
c) Set up hr = a *b	30
d) Set-ups cost ( per set-up hour)	300
e) Total set up cost ( c*d)	9000
f) Material movements per run	20
g) Total Material movements (f *a)	200
h) Material movements cost( g * $100.00 )	20000
i) Sales volume units	10000
j) Machine hours per unit	0.4
k) Total Machine hours ( i * j)	4000
l) Total Machine hours cost ( k * $ 30)	120000