Question

Background

You are a Consultant for the professional service firm, BUSI 2083 LLP. Your firm specializes in providing a wide variety of internal business solutions for different clients. It is your first day on the job and a Manager asks you for some help with a client in the aerospace sector. Eager to please on your first day, you head over to Galaxy Incorporated and sit down with the Executive Vice President to obtain more information.

“That R2D2 model is such a stinker! I think it's time to cut back its production and shift our resources toward the new BB8 model,” said Justin Medakiewicz, Executive VP of Galaxy Incorporated. “Take a look at this Income Statement I've received from accounting. The BB8 is generating over eight times as much profit as the R2D2 on one-sixth of the unit sales. I'm convinced that we should focus on the BB8 going forward.” The year-end statement which Justin was referring to is shown below.

		Model
	Total	R2D2	BB8
Sales	$11,125,000	$9,000,000	$2,125,000
Cost of Goods Sold	6,900,000	5,490,000	1,410,000
Gross Margin	4,225,000	3,510,000	715,000
Less: Selling and Administrative Expenses	3,675,000	3,450,000	225,000
Operating Income	$550,000	$60,000	$490,000
Number of Units Produced and Sold		30,000	5,000

“The numbers sure look that way,” replied Melissa Montoro, the company's sales manager. “But why isn't the competition interested in replicating the BB8? I know we've been producing the model for only three years, but I'm surprised that more of our competitors haven't recognized what a cash cow it is.”

“I think it's our new automated plant,” replied Justin. “Now it takes only two direct labour hours to produce a unit of the R2D2 and three direct labour hours to produce a unit of the BB8. That's considerably less than it used to take us.”

“I agree that automation is very beneficial,” replied Melissa. “I suppose that's how we're able to hold down the price of the BB8. Trekkie Corporation in the UK tried to bring out a BB8 but discovered they couldn't come close to matching our price. But Trekkie is killing us on the R2D2 by undercutting our price with some of our best customers. I suppose they'll pick up all of our R2D2 business if we move out of that market. But who cares? We don't even have to advertise the BB8; it just seems to sell itself.”

“My only concern about automation is how our manufacturing overhead rate has shot up,” said Justin. “Our total manufacturing overhead cost is $2,700,000. That comes out to be a hefty amount per direct labour hour, but Timothy down in accounting has been using direct labour hours as the base for computing overhead rates for years and doesn't want to change. I don't suppose it matters as long as costs get assigned to products.”

“I've never understood that debit and credit stuff,” replied Melissa. “But I think you've got a problem in production. I had lunch with Lily yesterday and she complained about how complex the BB8 is to produce. Apparently they have to do a lot of setups, special soldering, and other work on the BB8 just to keep production moving. And they have to inspect every single unit.”

“It'll have to wait,” said Justin. “I'm writing a proposal to the board of directors to phase out the R2D2. We've got to increase our bottom line or we'll all be looking for jobs.”

Compute the predetermined overhead rate based on direct labour hours that the company used during the year. (There was no underapplied or overapplied overhead for the year.)

Direct materials and direct labour costs per unit for the two products are as follows:

	R2D2	BB8
Direct Materials	$75	$120
Direct Labor	$36	$54

Using these data and the rate computed in (1) above, determine the unit product cost of each product under the company's traditional costing system.

Assume that the company's $2,700,000 in manufacturing overhead cost can be assigned to six activity cost pools as follows:

			Expected Activity
Activity Cost Pool	Estimated Overhead Costs	Total	R2D2	BB8
Machine setups (number of setups)	$  312,000	$ 1,600	1,000	600
Quality control (number of inspections)	540,000	9,000	4,000	5,000
Purchase orders (number of orders)	135,000	1,200	840	360
Soldering (number of solder joints)	675,000	200,000	60,000	140,000
Shipments (number of shipments)	198,000	600	400	200
Machine-related (machine-hours)	840,000	70,000	30,000	40,000
	$2,700,000

Given these data, would you support a recommendation to expand sales of the BB8? Explain your position.

From the data you prepared in (3) above, why do you suppose the BB8 “just seems to sell itself”?

If you were president of Galaxy Incorporated, what strategy would you follow from this point forward to improve the company's overall profits?

How might Galaxy Incorporated find the ABC information helpful in managing its business?

Answer 1

Answer:

Traditional costing system:

Manufacturing overhead cost = $2,700,000

It takes two direct labor hours to produce a unit of the R2D2 and three direct labor hours to produce a unit of the BB8

Total direct labor hours required = 30000 * 2 + 5000 * 3 = 75,000

Predetermined overhead rate based on direct labor hours = 2700000 / 75000 = $36

Activity Based Costing:

Calculation of cost driver and allocation of cost based on ABC:

Calculation of Unit product cost based on ABC:

Sale price of R2D2 = $9,000,000 / 30000 = $300

Sale price of BB8 = $2,125,000/ 5000 = $425

I would not support a recommendation to expand sales of the BB8.

The selling price of BB8 is $425 and unit product cost of the same based on ABC is $469.20. As such, in fact, BB8 is incurring losses.

Since Galaxy has followed traditional costing system and allocated overheads (which are significant %age of total cost) based on direct labor, the unit cost calculations are erroneous and this has resulted in erroneous pricing. BB8 is selling because Galaxy has erroneously set a lower price which competitors (who have correct costing) could not beat.  

If I were president of Galaxy Incorporated, the strategy I would follow from this point forward to improve the company's overall profits:

1. Implement activity based costing

2. Review pricing of both R2D2 and BB8

(i) Get unit cost of both product based on ABC

(ii) Gather information from market price (what prices are being offered by peers?)

(iii) Revise prices

Galaxy Incorporated will find the ABC information helpful in managing its business:

ABC system provides more precise allocation of cost based on cause and effect relationships. It identifies cost pools, drivers and allocates cost on more rational basis which results in more precise calculation of unit cost. When overhead costs are significant % of total cost any erroneous allocation will result in wrong costing and wrong pricing and erroneous decisions. In this case Galaxy were following wrong strategy which has led to lower pricing of BB8 and higher pricing of R2D2. ABC information is helpful to them to rectify their strategy to revise pricing based on more accurate costing and saves them from implementing erroneous decision (which would have proved disastrous for the company in long run).