Question

Classic Bicycles Inc. makes moderately expensive bikes and very high end custom bikes. The moderately expensive bikes sell for $600 apiece whereas the high end bikes sell for $8,000 apiece.

The Company uses an outside marketing agency to promote both of their products. The Company pays the agency $4,000,000 per year for marketing activities.

Income Statement

	High End	Moderate
Sales Quantity	1,000	20,000
Sales	$8,000,000	$12,000,000
Cost of Goods Sold	5,000,000	10,000,000
Gross Profit	3,000,000	2,000,000
Marketing Costs	1,600,000	2,400,000
Operating Income	1,400,000	(400,000)

40% of the total sales dollars are from High-End bikes
60% of the total sales dollars are from Moderate bikes.

The $4,000,000 in Marketing Costs has been allocated based on relative sales amounts. So, $1,600,000 is allocated to High-End bikes and $2,400,000 is allocated to Moderate Bikes.

The Board of Directors is considering dropping the Moderate Bike line. The CEO agrees. However one Board member has asked: “is the allocation of the marketing costs reasonable?”

In the past no one has solicited detailed cost information from the marketing Company. Upon your request the Marketing Company has provided the following information.

Marketing Costs
Directed Advertising	$1,600,000
Direct Calling	2,200,000
Product Demonstration	200,000
Total	4,000,000

Directed Advertisement    Cost $1,600,000
2,000 advertisements at $800 per ad.
1,200 advertisements for High-End Bikes
800 Advertisements for Moderate Bikes

Direct Calling     Cost $2,200,000
100,000 direct calls at $22 per call
100,000 direct calls for High-End Bikes
No direct calls for Moderate Bikes

Product Demonstrations Cost $200,000
400 Demonstrations at $500 per demonstration
80 Demonstrations for High-End Bikes
320 Demonstrations for Moderate Bikes

Required

Re-allocate Marketing Costs using ABC Techniques

Identify operating income by Product line with the new allocation

Make a recommendation about product line retention

Answer 1

Solution:

Determination of activity rate for marketing cost & allocation of marketing cost
Activity	Estimated Overhead Cost	Activity Base	Usage of Activity Base	Activity Rate	High End Bikes		Moderate Bikes
					Usage	Allocated Costs	Usage	Allocated Costs
Direct Advertising	$1,600,000.00	Nos of ads	2000	$800.00	1200	$960,000.00	800	$640,000.00
Direct Calling	$2,200,000.00	Nos of calls	100000	$22.00	100000	$2,200,000.00	0	$0.00
Product Demonstration	$200,000.00	Number of demonstration	400	$500.00	80	$40,000.00	320	$160,000.00
Total	$4,000,000.00					$3,200,000.00		$800,000.00

Computation of Net Operating Income (ABC)
Particulars	High End Bikes	Moderate Bikes
Sales	$8,000,000.00	$12,000,000.00
Cost of goods sold	$5,000,000.00	$10,000,000.00
Gross Profit	$3,000,000.00	$2,000,000.00
Marketing Cost	$3,200,000.00	$800,000.00
Operating Income	-$200,000.00	$1,200,000.00

On the basis of activity based costing, it is recommended Moderate bike lines should be retained. Company can consider dropping high end bikes line.