Question

Scenario

Cartech Manufacturing is engaged in the production of replacement parts for automobiles. One plant specializes in the production of two parts: Part 271 and Part 342. Part 271 produces the highest volume of activity, and for many years it was the only part produced by the plant. Five years ago, Part 342 was added. Part 342 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 past two years, however, the plant has faced intense competition, and its sales of Part 271 have 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 Tricia Goodson, plant manager, and Jackson Fielding divisional marketing manager, reflects the concerns of the division about the future of the plant and its products.

Jackson: You know, Tricia, the divisional manager is really 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.

Tricia: Joe, you and I both know that Part 271 has a reputation for quality and value. It has been a mainstay for years. I don’t understand what’s happening.

Jackson: I just received a call from one of our major customers concerning Part 271. 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.

Tricia: 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 342. Our margin is high on this product, and we have virtually no competition for it.

Jackson: 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.

Tricia: It sounds promising. However, before we make a major commitment to Part 342, I think we had better explore other possible explanations. I want to know how our production costs compare with those of our competitors. Perhaps we could be more efficient and find a way to earn our normal return on Part 271. The market is so much bigger for this part. I’m not sure we can survive with only Part 342. Besides, my production people hate that part. It’s very difficult to produce.

After her meeting with Jackson, Tricia requested an investigation of the production costs and comparative efficiency. She received approval to hire Wake Consulting Group to make an independent investigation.

You, as the staff accountant for Wake Consulting Group, have uncovered the following costs and activities associated with the two products.

	Part 271	Part 342
Production	500,000	100,000
Selling Price	$31.86	$24.00
Prime costs per unit	$9.53	$8.26
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

Overhead is allocated using a plant-wide rage based on direct labor hours.

Preliminary analysis of costs by Wake Consulting Group revealed that similar costs can be categorized into the following cost pools. Setup costs are costs that occur each time a new production run is made. They involve retooling and reconfiguring the machines and technology. Material handling costs include the equipment and personnel required to transport materials from supplier trucks to the machines. Typically, materials are taken to a storage area before being transported to machines. Each production run will need new materials and materials may also be transported during production runs. Machine costs primarily include depreciation and machine maintenance. Although the machines are depreciated using accelerated depreciation schedules, typically the machine wear out from use and are replaced before they become obsolete. Receiving costs include the costs of clerical and technical help associated with the processing of each order received from a customer. Engineering costs include the technical support staff that implement design changes in the part, manage processes to maintain quality, and provide technical information on the product. The engineering staff maintain a record of the amount of time spent on each product. General plant costs include all the other administrative costs not included in the other cost pools.

Overhead Cost Pools
Setup costs	$240,000
Material handling costs	$900,000
Machine costs	$1,750,000
Receiving costs	$2,100,000
Engineering costs	$1,500,000
General plant costs	$500,000
	TOTAL :    $6,990,000 Part 5: Recommendations – Materials have been sourced that will reduce Prime Costs by $1.50 for each part. It is also decide to reduce the price for Product 271 by 25%. Per unit Part 271 Part 342 Selling Price $ $ Product Cost Prime costs $ $ Overhead $ $ Total Product Cost $ $ Total Profit $ $ Part 6: Another reasonable recommendation to improve profitability. Explain your recommendation here- Per unit Part 271 Part 342 Selling Price $ $ Product Cost Prime costs $ $ Overhead $ $ Total Product Cost $ $ Total Profit $ $

Answer 1

Solution Part 5:

Calculation of Profit per unit with the reduction in Prime cost by $1.50 for each part and reduction in Selling Price of Part 271 by 25%.

New Selling Price of Part 271 = $31.86 – 25% = $23.90

Distribution of Overheads as per Direct Labour Hours

Total Direct Labour Hours

= Direct Labour Hours for Part 271 + Direct Labour Hours for Part 342

= 250,000 + 22,500 = 272,500

Overhead Rate per Direct Labour Hour = Total Overheads $ / Total Direct Labour Hours

                                                                      = $6,990,000 / 272,500 Hours = $25.65 per hour

Total Overheads Allocated to Part 271 = 250,000 Hours x $25.65 per hour = $6,412,844.037

Therefore, Overhead Cost per unit for Part 271 = $6,412,844.037 / 500,000 units = $12.83 per unit

        

Total Overheads Allocated to Part 342 = 22,500 Hours x $25.65 per hour = $577,155.96

Therefore, Overhead Cost per unit for Part 271 = $6,412,844.037 / 100,000 units = $5.77 per unit        

Per Unit	Part 271 $	Part 342 $
Selling Price	23.90	24
Product Cost
Prime Costs	8.03	6.76
Overheads	12.83	5.77
Total Product Cost	20.86	12.53
Total Profit	3.04	11.47

Therefore, with the recommendation of reduction in Prime cost by $1.50 for each part and reduction in Selling Price of Part 271 by 25%, Profit per unit is $3.04 for Part 271 and $11.47 for Part 342.

Solution Part 6) Instead of reducing the Selling Price of Part 271 and changing the source of material, management should adopt Activity Based Costing technique to allocate Overheads instead of Direct Labour Hours.

Calculation of Rate Per Cost Driver as per Activity Based Costing

Activity	Cost $	Cost Driver	Number of Cost Drivers (Part 271 + Part 342)	Rate Per Cost Driver = Cost $ / Number of Cost Drivers
Setup costs	2,40,000.00	Number of production runs	300	800.00
Material handling costs	9,00,000.00	Material Moves	900	1,000.00
Machine costs	17,50,000.00	Machine hours	1,85,000	9.46
Receiving costs	21,00,000.00	Receiving orders	1,400	1,500.00
Engineering costs	15,00,000.00	Engineering hours	10,000	150.00
General plant costs	5,00,000.00	Direct labor hours	2,72,500	1.83
	69,90,000.00

Calculation of Overhead Cost per Unit as per Activity Based Costing

	Part 271			Part 342
Costs	Number of Activities	Activity Rate $	Cost $	Number of Activities	Activity Rate $	Cost $
Setup costs	100	800.00	80,000.00	200	800.00	1,60,000.00
Material handling costs	500	1000.00	5,00,000.00	400	1000.00	4,00,000.00
Machine costs	1,25,000	9.46	11,82,432.43	60,000	9.46	5,67,567.57
Receiving costs	400	1500.00	6,00,000.00	1,000	1500.00	15,00,000.00
Engineering costs	5,000	150.00	7,50,000.00	5,000	150.00	7,50,000.00
General plant costs	2,50,000	1.83	4,58,715.60	22,500	1.83	41,284.40
Total Overhead Cost $	35,71,148.03			34,18,851.97
Number of Units	5,00,000			1,00,000
Overhead Cost per Unit $	7.14			34.19

Calculation of Total Profit per unit using Activity Based Costing

Per Unit	Part 271 $	Part 342 $
Selling Price	31.86	24.00
Product Cost
Prime Costs	9.53	8.26
Overheads	7.14	34.19
Total Product Cost	16.67	42.45
Total Profit	15.19	-18.45

As per Activity based Costing, Part 271 is generating a profit of $15.19 per unit while Part 342 is incurring a loss of $18.45 per unit.