Question

SmartAuto 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 Patricia Wang, plant manager, and James Tin, divisional marketing manager, reflects the concerns of the division about the future of the plant and its products.

JAMES:           You know, Patricia, 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.

PATRICIA:      James, 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.

JAMES:           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.

PATRICIA:      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.

JAMES:           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.

PATRICIA:      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 James, Patricia 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:

Should the company switch its emphasis from the high-volume product to the low-volume product? Comment on the validity of the plant manager's concern that competitors are selling below the cost of making Part #127.

Answer 1

No, company should not switch its emphasis from high volume product tti the lowvolume product. also, plant manager's concern is not valid that competitors are selling below the cost ofr making part # 127.

Following calculations proof the same:

1 .Calculation of Expected Activity
Activity cost pool	Activity	Part #127	Part #234	Total (Expected Activity)
Setup Cost	No of production runs	100	200	300
Machine cost	Machine hours	125000	60000	185000
Receiving Cost	Receiving orders	400	1000	1400
Engineering Cost	Engineering Hours	5000	5000	10000
Materials Handling cost	Material Moves	500	400	900
Calculation of overhead rate
Activity cost pool	Cost ($) (A)	Expected activity (B)	Rate (A/B)
Setup Cost	240000	300	800
Machine cost	1750000	185000	9.46
Receiving Cost	2100000	1400	1500
Engineering Cost	2000000	10000	200
Materials Handling cost	900000	900	1000
Overhead Cost allocated to Part # 127
	rate (A)	activity (B)	cost allocated (A*B)
Setup Cost	800.00	100.00	80000.00
Machine cost	9.46	125000.00	1182432.43
Receiving Cost	1500.00	400.00	600000.00
Engineering Cost	200.00	5000.00	1000000.00
Materials Handling cost	1000.00	500.00	500000.00
Total			3362432.43
No of units Produced			500000.00
Overhead per unit			6.72
Overhead Cost allocated to Part # 234
	rate (A)	activity (B)	cost allocated (A*B)
Setup Cost	800.00	200.00	160000.00
Machine cost	9.46	60000.00	567567.57
Receiving Cost	1500.00	1000.00	1500000.00
Engineering Cost	200.00	5000.00	1000000.00
Materials Handling cost	1000.00	400.00	400000.00
Total			3627567.57
No of units Produced			100000.00
Overhead per unit			36.28
Calculation of unit cost
	Part # 127	Part # 234
Prime cost	8.53	6.26
Overhead Cost (Notes)	6.72	36.28
Total	15.25	42.54
Calculation of Contribution p u
	Part # 127	Part # 234
Selling Price Per unit	31.86	30	(24*125%)
Less:
Variable cost	15.25	42.54
Contribution	16.61	-12.54