Description
Premier Products, Inc. manufactures tennis rackets. Premier Products has grown
extensively over the past two years. While the company has been very profitable,
President Mark Harrison is concerned with its ability to cost products accurately. Some
products appear to be very profitable while others, which should be showing a profit,
seem to be losing money. The production manager is convinced that his production
processes are as efficient as any in the industry, and he is unable to explain the apparent
high cost of producing some of the products.
Harrison agreed with his production manager and is convinced that the cost accounting
system is at fault. He has hired Tom Arnold, a management consultant, to analyze the
firm’s costing system. Arnold has documented the existing costing system. It is a very
simple system that uses a single allocation rate for all overhead costs. The overhead rate
for the year is determined by adding together the budgeted variable and fixed overhead
costs and dividing this sum by the number of budgeted labor hours. The standard cost of
a product is found by multiplying the number of direct labor hours required to
manufacture that product by the overhead rate and adding this quantity to the direct labor
and material costs.
Arnold is convinced that the company’s costing system is partially to blame for some of
the firm’s problems. He has assembled data for four of Premier’s products. He has put
together the actual costs required for each of these products in Table A. These costs will
serve as the benchmark against which the results of different allocation schemes can be
evaluated.
Of course, in real life we could never start out with accurate actual costs – accurate actual
costs would be the end result that we would attempt to determine. But we provide this
information as a learning aid to help you to clearly understand the key issues. Table A is
as follows:
PRODUCT
A
B
C
D
Material
$15.00
$ 5.00
$10.00
$ 5.00
+ Labor
30.00
5.00
15.00
10.00
+Variable OH
15.00
7.50
5.00
7.50
= Unit var. cost
$60.00
$17.50
$30.00
$22.50
Fixed overhead
$10,000
$10,000
$12,500
$12,500
Units produced
1,000
1,000
1,000
1,000
Unit fixed cost
$10.00
$10.00
$12.50
$12.50
1
Total unit cost
$70.00
$27.50
$42.50
$35.00
The manufacturing processes for these products are structured such that the same labor
and equipment can be used to produce products A and B but cannot be used to
manufacture products C and D. Similarly, the labor and equipment used to manufacture
products C and D cannot be used for A and B.
The company has the capacity to produce:
(1) 1,000 units of product A and 1,000 units of product B, or
(2) 2,000 units of product A, or
(3) 2,000 units of product B; or
(4) Any linear combination of products A and B.
The same is true for products C and D. The company has the capacity to produce:
(1) 1,000 units of product C and 1,000 units of product D, or
(2) 2,000 units of product C, or
(3) 2,000 units of product D; or
(4) Any linear combination of products C and D.
Product
Labor hrs
per unit
Variable
Ohd/unit
Number of
units
Total labor
hrs
Total var ohd
A
6
$15.00
1,000
6,000
$15,000
B
1
7.50
1,000
1,000
7,500
C
3
5.00
1,000
3,000
5,000
D
2
7.50
1,000
2,000
7,500
4,000
12,000
$35,000
Total
The allocation rate is:
2
Variable overhead
$35,000
Fixed overhead
45,000
Total overhead costs
$80,000
Labor hours
12,000
Allocation rate per hour
$6.67
Using this allocation rate, Arnold calculated the standard cost for the four products.
PRODUCT
A
B
C
D
Material
$15.00
$ 5.00
$10.00
$ 5.00
+ Labor
30.00
5.00
15.00
10.00
+Allocated cost
40.00
6.67
20.00
13.33
Total unit cost
$85.00
$16.67
$45.00
$28.33
The selling prices for the four products are:
A
B
C
D
$98.00
$38.50
$59.50
$49.00
Premier is considering a policy that would discontinue a product if its mark-on is under
25%. The mark-on is calculated by taking the selling price, subtracting the product’s
standard cost, and dividing by the standard cost. Harrison is concerned that if the firm’s
costing system does not provide accurate cost estimates, products will be dropped that
should be retained. Arnold calculated that the mark-on for each product using the correct
product costs in Table A is 40%.
3
TABLE B
PRODUCT
A
B
C
D
Selling price
$98.00
$38.50
$59.50
$49.00
Unit cost
$70.00
$27.50
$42.50
$35.00
Profit
$28.00
$11.00
$17.00
$14.00
Mark-on
percentage
40% (28/70)
40% (11/27.50)
40% (17/42.50)
40% (14/35)
Arnold then calculated the mark-on for the four products using the standard cost for each
product based on allocating the overhead costs using direct labor hours.
PRODUCT
A
B
C
D
Selling price
$98.00
$38.50
$59.50
$49.00
Unit cost
$85.00
$16.67
$45.00
$28.33
Profit
$13.00
$21.83
$14.50
$20.67
Mark-on
percentage
15%
131%
32%
73%
Under the policy of dropping products with mark-ons under 25%, product A would be
dropped. Arnold recalculates the allocation rate assuming product A is dropped and the
manufacturing capacity is shifted to produce an additional 1,000 units of product B.
Product
Labor hrs
per unit
Variable
Ohd/unit
Number of
units
Total labor
hrs
Total var ohd
B
1
7.50
2,000
2,000
$15,000
C
3
5.00
1,000
3,000
5,000
D
2
7.50
1,000
2,000
7,500
4,000
7,000
$27,500
Total
4
The new allocation rate is:
Variable overhead
$27,500
Fixed overhead
45,000
Total overhead costs
$72,500
Labor hours
7,000
Allocation rate per hour
$10.36
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NOTE: A product’s contribution margin is its selling price minus its variable cost per unit.
1. Under what conditions would direct labor hours accurately allocate Premier’s indirect costs to its four products? What are the characteristics of a cost accounting system that accurately allocates a company’s fixed and variable indirect costs to its products?
2. Tom Arnold was hired to find accurate costs and a method of allocating that allows decisions to improve profitability. Compare the profits and accuracy of all cost allocation schemes based on Tom Arnold’s initial reason for being hired.
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