5-52 Volume-based Costing Versus ABC 1. (1) Target price $279.00 $294.00 $199.50 (2) Manufacturing cost (1) 150% $186.00 $196.00 $133.00 Prime cost - 70.00-126.40-75.00 Overhead cost per unit $116.00 $ 69.60 $ 58.00 Number of units x 1,000 x 5,000 x 500 Total overhead $116,000 $348,000 $29,000 2. Current Costing system Actual selling price $280 $250 $300 Product manufacturing cost 186 196 133 Gross margin $ 94 $ 54 $167 Gross margin ratio 33.57% 21.6% 55.67% Based on the current cost data, it is true that product B is the least profitable product with a gross margin per unit of $54.00 (21.6%) and product C is the most profitable product with a gross margin per unit of $167.00 (55.67%). However, the validity of this conclusion is based on the accuracy of the reported product costs. Product costs based on the activity-based costing system Direct materials $ 50.00 $114.40 $ 65.00 Direct labor 20.00 12.00 10.00 Factory overhead: Setups (a) 1.60 0.80 4.80 Materials handling (b) 40.00 5.00 70.00 Hazardous control (c) 62.50 22.50 150.00 Quality control (d) 22.50 5.25 52.50 Utilities (e) 12.00 8.40 12.00 Total $208.60 $168.35 $364.30 Actual selling price $280.00 $250.00 $300.00 Product manufacturing cost 208.60 168.35 364.30 Gross margin $ 71.40 $ 81.65 ($64.30) Gross margin ratio 25.50% 32.66% (21.43)% 1
5-52 (continued) Notes: (a) Setups: Cost per setup: $8,000 / (2 + 5 + 3) = $800 per setup Product A = 2 x $800 = $1,600; $1,600 /1,000 = $1.60 per unit Product B = 5 x $800 = $4,000; $4,000 /5,000 = $0.80 per unit Product C = 3 x $800 = $2,400; $2,400 /500 = $4.80 per unit (b) Materials handling: Cost per pound = $100,000 / (400 + 250 + 350) = $100 per pound Product A = 400 x $100 = $40,000; $40,000/1,000 = $40.00 per unit Product B = 250 x $100 = $25,000; $25,000/5,000 = $ 5.00 per unit Product C = 350 x $100 = $35,000; $35,000/500 = $70.00 per unit (c) Waste and hazardous disposals: Cost per disposal: $250,000/(25 + 45 + 30) = $2,500 per disposal Product A = 25 x $2,500 = $ 62,500; $ 62,500/1,000 = $ 62.50/unit Product B = 45 x $2,500 = $112,500; $112,500/5,000 = $ 22.50/unit Product C = 30 x $2,500 = $ 75,000; $ 75,000/500 = $150.00/unit (d) Quality inspections: Cost per inspection = $75,000/(30 + 35 + 35) = $750 per inspection Product A = 30 x $750 = $22,500; $22,500/1,000 = $22.50 per unit Product B = 35 x $750 = $26,250; $26,250/5,000 = $ 5.25 per unit Product C = 35 x $750 = $26,250; $26,250/500 = $52.50 per unit (e) Utilities: Cost per MH = $60,000 / (2,000 + 7,000 + 1,000) = $6.00 per MH Product A = 2,000 x $6 = $12,000; $12,000/1,000 = $12.00 per unit Product B = 7,000 x $6 = $42,000; $42,000/5,000 = $ 8.40 per unit Product C = 1,000 x $6 = $ 6,000; $ 6,000/500 = $12.00 per unit 2
5-52 (continued-2) 3. Comparison of reported product costs, new target price, actual selling price, and gross margin (loss): Product costs: 1. Direct-labor based system $186.00 $196.00 $133.00 2. Activity-based system $208.60 $168.35 $364.30 ABC-based product costs: Target price (150%) $312.90 $252.53 $546.45 Actual selling price $280.00 $250.00 $300.00 Difference in price <$32.90> <$2.53> <$246.45> Direct-labor based costing system Gross margin $ 94 $ 54 $167 Gross margin ratio 33.57% 21.6% 55.67% Activity-based costing system: Gross margin $71.40 $81.65 $(64.30) Gross margin ratio 25.50% 32.66% <21.43%> 4. Strategic and Competitive Analysis 1. Emphasizing Product C as suggested by the current directlabor-cost based overhead costing system is likely to harm the firm s competitiveness. The activity-based costing system shows that the manufacturing cost of Product C is $364.30 per unit and, at the current selling price, the firm suffers a $64.30 loss for each unit it manufactures and sells. 2. If the actual selling prices of products A & B are fair market prices for these products and a markup of 150% is a common industry practice, the firm needs to examine the manufacturing cost of product A. The fact that the firm s target price, determined using 150% of the manufacturing cost, is more than 10 percent over the fair market price of the product suggests possible wastes and inefficiencies in the manufacturing of product A. 3
5-54 Volume-Based Costing Versus ABC 1. Current costing system (direct-labor hour) Deluxe % Speedy % Price $475 100 $300.00 100 Prime Cost 180 38 110.00 37 Overhead 20 4 153.60 51 Unit gross profit $275 58 $ 36.40 12 2. Multiple drivers costing system Calculation of unit overhead costs - Deluxe: Deluxe Setups $2,800 x 200 = $ 560,000 Machine costs $100 x 100,000 = 10,000,000 Engineering $40 x 45,000 = 1,800,000 Packing $20 x 50,000 = 1,000,000 Total overhead $13,360,000 Number of Units 50,000 Overhead per unit $267.20 Calculation of unit overhead costs - Speedy: Speedy Setups $2,800 x 100 = $ 280,000 Machine costs $100 x 400,000 = 40,000,000 Engineering $40 x 120,000 = 4,800,000 Packing $20 x 200,000 = 4,000,000 Total overhead $49,080,000 Number of Units 400,000 Overhead per unit $122.70 Deluxe % Speedy % Price $475.00 100 $300.00 100 Cost Prime cost $180.00 $110.00 Overhead 267.20 447.20 94 122.70 232.70 78 Unit gross profit $27.80 6 $67.30 22 4
5-54 (continued) 3. Using the activity-based costing, a much different picture on profitability of the Deluxe and Speedy models emerges. The Speedy model is actually more profitable than the Deluxe model. The revised cost data suggests that shifting the emphasis to the Deluxe model may very well be a mistake. The Deluxe printer is a much heavier user of overhead resources as can be seen in the table below that compares uses of overhead. Overhead Activity Consumption Activity Deluxe Speedy Setups 250 units per setup 4,000 units per setup Machine costs 2 MH per unit 1 MH per unit Engineering 0.9 Engr. Hr. per unit 0.3 Engr. Hr. per unit Packing 1 unit per packing order 2 units per packing order Supporting calculations Activity Consumption Deluxe Speedy Total Per Activity Measure Total Per Activity Measure Units 50,000 400,000 Setups 200 250 units per setup 100 4,000 units per setup Machine costs 100,000 2 MH per unit 400,000 1 MH per unit Engineering 45,000 0.9 Engineering Hours per unit 120,000 0.3 Engineering hours per unit Packing 50,000 1 unit per packing 200,000 2 units per packing order order 4. The ABC method is likely to provide Gorden Company a more accurate product cost picture. It also directs the management s attention to the high volume, more profitable Speedy printers. Given the low profit margin of the Deluxe, the firm may want to investigate the feasibility of raising the price, the possibility of reducing product cost, or both. 5