Question

To help illustrate the source of these distortions to senior management, Peterzon decided to develop a simple four-product model. He decided it would be helpful if the actual production costs of the four products were known a priori (see Table A).

	A	B	C	D
Material cost	15	5	10	5
Direct labor	30	5	15	10
Variable overhead	15	7.5	5	7.5
Variable Cost	60	17.5	30	22.5
Fixed Cost	10	10	12,500	12,500

Product lines A and B used identical equipment that could each produce 1,000 units of A
or B. Product lines C and D used identical equipment that could each produce 1,000 units of C or D.
He then calculated the direct labor allocation rate that the existing single burden rate cost system would generate assuming that each product sold a thousand units, the maximum that could be produced, and that each direct labor hour cost $5. Under this scenario, the costs incurred would be:

Variable Product Overhead	Labor Hours Per Unit	Variable Overhead/unit	No. Units	Total Labor Hours	Total
A	6	15	1	6	15
B	1	7.5	1	1	7.5
C	3	5	1	3	5
D	2	7.5	1	2	7.5
Total			4	12	35

and the new allocation rate:

Variable overhead	35,000
Fixed Overhead	45,000
Total Cost to be Allocated	80,000
Labor Hours ($60,000/5)	12,000
Allocation rate/hour	$6.67

Using this allocation rate per hour, Peterzon calculated the standard cost of the four products.

Product	A	B	C	D
Material	15	5	10	5
Labor	30	5	15	10
Allocated Cost	40	6.67	20	13.33
Standard Cost	$85	16.67	45	28.34

If the firm set out to make a 40% mark-on,b then it would want to charge the following prices for the four products:

Product	A	B	C	D
Standard Cost	85	16.67	45	28.34
40% Mark-on	34	6.67	18	11.34
Selling Price	$119	23.34	63	39.68

Mark-on % = profit/cost

If industry selling prices were established using actual production costs and a 40% mark-on, they would be:

Product	A	B	C	D
Standard Cost	70	27.5	42.5	35
40% Mark-on	28	11	17	14
Selling Price	$98	38.5	59.5	49

By comparing the "industry" prices to the firm's costs and assuming that the firm had to match industry prices, Peterzon could determine which products would appear profitable.

Selling Price	98	38.5	59.5	49
Standard Cost	85	16.67	45	28.34
Profit	13	21.83	14.5	20.66
Markup	15%	131%	32%	73%

CCI had recently adopted a policy of discontinuing all products whose mark-ons were under 25%. Under this policy, product A would be dropped and additional product B manufactured. Assuming the firm could sell all of product B that it could manufacture, then the sales would be

Budgeted	A	B	C	D
Current Volume	1,000	1,000	1,000	1,000
Actual Volume	0	2,000	1,000	1,000

The unused production capacity was used to produce an additional 1,000 units of B.

The resulting product mix was so different from the starting mix that Peterzon decided to recalculate the allocation rate per hour to determine if it had been affected:

Costs Incurred ($ thousand)

Variable Product Overhead	Labor Hours/Unit	Variable Overhead/ Unit	No. Units	Total Labor Hours	Total
B	1	7.5	2,000	2,000	15,000
C	3	5	1,000	3,000	5,000
D	2	7.5	1,000	2,000	7,500
Total			4,000	7,000	27,500

and the new allocation rate:

Variable Overhead : 27,500

Fixed Overhead: 45,000

72,500

Labor Hours ( 35,000/5) : 7,000

Allocation rate/hour: $10.36

Q1) What will CCI now have to charge for each product to make 40% mark-on? If CCI maintains its rule about dropping products with a mark-on below 25%, which additional products, if any, will it drop?   

Variable cost per product ( $ per unit)
	A	B	C	D
Material Cost
Direct Labor
Variable overhead
Variable cost

Standard costs ($)	A	B	C	D
Material Cost
Direct Labor
Variable Overhead allocation
Fixed overhead allocation
Standard full cost
Selling price based on actual costs with 40% mark on (given in the case)
Selling price based on standard costs with 40% mark on (given in the case)

Analysis table	A	B	C	D
Mark on % (actual cost based selling price-standard full cost)/standard full cost)
contribution margin (actual cost based selling price-variable cost)

Based on above analysis which product(s) will drop off? Why? Explain briefly

Based on above fill out the table below for total production and sale ($):

Do not fill out the column for dropped off product.

Gross profitability table based on production	A	B	C	D	Total
Number of units produced
Revenue based on actual cost price
Total variable cost
Contribution margin
Fixed costs
Gross margin

Q2: Alternatively if the rule was to drop the product with the lowest contribution margin, which product would you drop? Please fill out the tables below for the remaining products:

Variable product overhead	Labor hours per unit	variable overhead/unit	no. of units	total labour hours	total
Total

New allocation rate:
variable overhead
fixed overhead
total cost to b allocated
labor hours
Allocation rate ($per hour)

Do not fill out the column for dropped off product.

Standard costs ($)	A	B	C	D
Material Cost
Direct Labor
Variable Overhead allocation
Fixed overhead allocation
Standard full cost
Selling price based on actual costs with 40% mark on (given in the case)
Selling price based on standard costs with 40% mark on (given in the case)

Do not fill out the column for dropped off product.

Analysis table	A	B	C	D
Mark on % (actual cost based selling price-standard full cost)/standard full cost)
contribution margin (actual cost based selling price-variable cost)

Based on above analysis which product(s) will drop off? Why? Explain briefly.

Based on above fill out the table below for total production and sale ($):

Do not fill out the column for dropped off product.

Gross profitability table based on production	A	B	C	D	Total
Number of units produced
Revenue based on actual cost price
Total variable cost
Contribution margin
Fixed costs
Gross margin

Answer 1

	A	B	C	D
Sales	0	2000	1000	1000
No of labor hours per unit	0	1	3	2
Total labor hours		2000	3000	2000	7000
Variable overhead per unit		7.5	5	7.5
Variable overhead costs total		15000	5000	7500	27500
Fixed overhead					45000
Total overheads					72500
Hours					7000
Overhead rate					10.35714

Standard costs
	A	B	C	D
Material costs		5	10	5
Direct labor		5	15	10
Allocated overhead		10.35	31.05	20.7
Standard costs		20.35	56.05	35.7
40% Mark-up		8.14	22.42	14.28
Selling Price		28.49	78.47	49.98

Actual costs
	A	B	C	D
Material costs		5	10	5
Direct labor		5	15	10
Variable		7.5	5	7.5
Fixed		10	12.5	12.5
Actual costs		27.5	42.5	35
40% Mark-up		11	17	14
Selling Price		38.5	59.5	49

Gross Profitability Table	Product A dropped off
	A	B	C	D
No of units produced		2000	1000	1000
Price		38.5	59.5	49
Revenue		77000	59500	49000
Material costs		10000	10000	5000
Direct labor		10000	15000	10000
Variable overheads		15000	5000	7500
Total variable costs		35000	30000	22500
Contribution Margin		42000	29500	26500
Fixed costs		20000	12500	12500
Gross Margin		22000	17000	14000
Based on contribution margin no product will be dropped off

Gross Profitability Table	Product A and C dropped off
	A	B	C	D
No of units produced		2000	0	2000
Price		38.5	59.5	49
Revenue		77000	0	98000
Material costs		10000	0	10000
Direct labor		10000	0	20000
Variable overheads		15000	0	15000
Total variable costs		35000	0	45000
Contribution Margin		42000	0	53000
Fixed costs		20000	0	25000
Gross Margin		22000	0	28000
Product A and C dropped off

Product A dropped off
Sales	0	2000	0	1000
No of labor hours per unit	0	1		2
Total labor hours		2000		2000	4000
Variable overhead per unit		7.5		7.5
Variable overhead costs total		15000		7500	22500
Fixed overhead					45000
Total overheads					67500
Hours					4000
Overhead rate					16.875

Standard costs
	A	B	C	D
Material costs		5		5
Direct labor		5		10
Allocated overhead		16.875		33.75
Standard costs		26.875		48.75
40% Mark-up		10.75		19.5
Selling Price		37.625		68.25

Actual costs
	A	B	C	D
Material costs		5		5
Direct labor		5		10
Variable		7.5		7.5
Fixed		10		12.5
Actual costs		27.5		35
40% Mark-up		11		14
Selling Price		38.5		49

Selling Price		38.5		49
Standard costs		26.875		48.75
Profit		11.625		0.25
% Profit		43%		1%
Variable costs		17.5		22.5
Contribution Margin		21		26.5
%		120%		118%
Based on Mark-up product D will be droped off

Gross Profitability Table	Product A and CD dropped off
	A	B	C	D
No of units produced		2000	0	0
Price		38.5	59.5	49
Revenue		77000	0	0
Material costs		10000	0	0
Direct labor		10000	0	0
Variable overheads		15000	0	0
Total variable costs		35000	0	0
Contribution Margin		42000	0	0
Fixed costs		45000	0	0
Gross Margin		-3000	0	0

If either of product C or D are dropped off there would be unutilised capacity which will generate additional fixed costs, unless and untill there is a positive contribution margin of any product the company shall continue the same to cover all the fixed costs

All the products have positive contribution margin hence, to maximize returns no product shall be dropped according to contribution margin method