Question

Product-Costing Accuracy, Corporate Strategy, ABC

Autotech Manufacturing is engaged in the production of replacement parts for automobiles. One plant specializes in the production of two parts: Part #127 and Part #234. Part #127 produced the highest volume of activity, and for many years it was the only part produced by the plant. Five years ago, Part #234 was added. Part #234 was more difficult to manufacture and required special tooling and setups. Profits increased for the first three years after the addition of the new product. In the last two years, however, the plant faced intense competition, and its sales of Part #127 dropped. In fact, the plant showed a small loss in the most recent reporting period. Much of the competition was from foreign sources, and the plant manager was convinced that the foreign producers were guilty of selling the part below the cost of producing it. The following conversation between Patty Goodson, plant manager, and Joseph Fielding, divisional marketing manager, reflects the concerns of the division about the future of the plant and its products.

JOSEPH: You know, Patty, the divisional manager is real concerned about the plant's trend. He indicated that in this budgetary environment, we can't afford to carry plants that don't show a profit. We shut one down just last month because it couldn't handle the competition.

PATTY: Joe, you and I both know that Part #127 has a reputation for quality and value. It has been a mainstay for years. I don't understand what's happening.

JOSEPH: I just received a call from one of our major customers concerning Part #127. He said that a sales representative from another firm offered the part at $20 per unit—$11 less than what we charge. It's hard to compete with a price like that. Perhaps the plant is simply obsolete.

PATTY: No. I don't buy that. From my sources, I know we have good technology. We are efficient. And it's costing a little more than $21 to produce 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. Perhaps a better strategy is to emphasize producing and selling more of Part #234. Our margin is high on this product, and we have virtually no competition for it.

JOSEPH: You may be right. I think we can increase the price significantly and not lose business. I called a few customers to see how they would react to a 25 percent increase in price, and they all said that they would still purchase the same quantity as before.

PATTY: It sounds promising. However, before we make a major commitment to Part #234, I think we had better explore other possible explanations. I want to know how our production costs compare to those of our competitors. Perhaps we could be more efficient and find a way to earn our normal return on Part #127. The market is so much bigger for this part. I'm not sure we can survive with only Part #234. Besides, my production people hate that part. It's very difficult to produce.

After her meeting with Joseph, Patty requested an investigation of the production costs and comparative efficiency. She received approval to hire a consulting group to make an independent investigation. After a three-month assessment, the consulting group provided the following information on the plant's production activities and costs associated with the two products:

	Part #127		Part #234
Production	500,000		100,000
Selling price	$31.86		$24.00
Overhead per unit*	$12.83		$5.77
Prime cost per unit	$8.53		$6.26
Number of production runs	100		200
Receiving orders	400		1,000
Machine hours	125,000		60,000
Direct labor hours	250,000		22,500
Engineering hours	5,000		5,000
Material moves	500		400

^* Calculated using a plantwide rate based on direct labor hours. This is the current way of assigning the plant’s overhead to its products.

The consulting group recommended switching the overhead assignment to an activity-based approach. It maintained that activity-based cost assignment is more accurate and will provide better information for decision making. To facilitate this recommendation, it grouped the plant's activities into homogeneous sets with the following costs:

Overhead:
Setup costs		$ 240,000
Machine costs		1,750,000
Receiving costs		2,100,000
Engineering costs		2,000,000
Materials-handling costs		900,000
Total		$6,990,000

Required:

1. Verify the overhead cost per unit reported by the consulting group using direct labor hours to assign overhead. Round your interim calculations and answers to the nearest cent.

Overhead rate	$ per direct labor hour
Part #127	$ per unit
Part #234	$ per unit

Compute the per-unit gross margin for each product. Round your answers to the nearest cent.

Part #127	$ per unit
Part #234	$ per unit

2. After learning of activity-based costing, Patty asked the controller to compute the product cost using this approach. Recompute the unit cost of each product using activity-based costing. Round your interim calculations and answers to the nearest cent.

Part #127	$ per unit
Part #234	$ per unit

Compute the per-unit gross margin for each product. Round your answers to the nearest cent. If an answer is a loss, use a minus (-) sign to indicate.

Part #127	$ per unit
Part #234	$ per unit

Answer 1

1.

Overhead Rate	$25.65 per direct labor hour
Part #127	$12.83 per unit
Part #234	$5.77 per unit
Working:
Overhead cost	6990000	25.65	per DLH
Direct Labor Hours	272500
Overhead assigned	Activity	Plantwide	Total	Units	OH cost
	Driver	ovehread	Overhead	Produced	per unit
		rate	cost
Part #127	250000	25.65	6412844	500000	12.83
Part #234	22500	25.65	577156	100000	5.77

Gross profit per unit
Part #127	$10.50
Part #234	$11.97
Working:
	Part #127	Part #234
Prime Cost	$8.53	$6.26
Overhead Cost per unit	$12.83	$5.77
Total manufacturing cost per unit	$21.36	$12.03
	Part #127	Part #234
Market price	$31.86	$24.00
Cost of manufacture	$21.36	$12.03
Gross profit	$10.50	$11.97

2.

	Part #127	Part #234
Prime cost per unit	8.53	6.26
Overhead Cost per unit	6.72	36.28
Total manufacturing cost per unit	15.25	42.54
	Part #127	Part #234
Market Price	31.86	24.00
Manufacturing cost per unit	15.25	42.54
Gross profit per unit	16.61	-18.54

Working:

Setup costs	240000	800.00	Per prodn.run
Production runs	300
Machine costs	1750000	9.46	per machine hour
Machine hours	185000
Receiving Costs	2100000	1500.00	per order
Receiving Orders	1400
Engineering hours	2000000	200.00	per eng.hour
Engineering hours	10000
Material handling Costs	900000	1000.00	Per move
Material Moves	900
Overhead Assigned
	Activity driver		Activity rate		Total
Part #127					overhead
Setup costs	100	production runs	800.00	per production run	80000
Machine costs	125000	machine hours	9.46	per machine hour	1182432
Receiving Costs	400	Orders	1500.00	per batch	600000
Engineering hours	5000	engineering hr.	200.00	per hour	1000000
Material handling Costs	500	Moves	1000.00	per move	500000
Total overhead					3362432
Production					500000
Overhead cost per unit					6.72
	Activity driver		Activity rate		Total
Part #234					overhead
Setup costs	200	production runs	800.00	per production run	160000
Machine costs	60000	machine hours	9.46	per machine hour	567568
Receiving Costs	1000	Orders	1500.00	per batch	1500000
Engineering hours	5000	engineering hr.	200.00	per hour	1000000
Material handling Costs	400	Moves	1000.00	per move	400000
Total overhead					3627568
Production					100000
Overhead cost per unit					36.28