Question

Autotech 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 produces 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 past two years, however, the plant has faced intense competition, and its sales of Part 127 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 Patty Goodson, plant manager, and Joseph Fielding divisional marketing manager, reflects the concerns of the division about the future of the plant and its products. Joseph: You know, Patty, 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. Patty: Joe, 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. Joseph: 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. Patty: 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. Idon'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. Joseph: You may be right. I think we can increase the price significantly and not loose 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. Patty: 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 with 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.

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Answer 1

	Part1	Plantwide overhead rate is based on direct labor hours
	A	Total overhead cost	$6,990,000
	B	Total direct labor hours	272500	(250000+22500)
	C=A/B	Plant wide overhead rate	$25.65	per direct labor hour
	D	Overhead allocated to Part 127	$6,412,844	(25.65*250000)
	E	Production in units	500,000
	E=D/E	Production Overhead per unit	$12.83
	G	Overhead allocated to Part 234	$577,156	(25.65*22500)
	H	Production in units	100,000
	I=G/H	Production Overhead per unit	$5.77
			Part127	Part234
		Overhead/Unit	$12.83	$5.77
		Gross Margin:
	a	Selling Price /Unit	$31.86	$24.00
	b	Prime costs/unit	$9.53	$8.26
	c	Overhead/Unit	$12.83	$5.77
	d=a-b-c	Gross Margin/unit	$9.50	$9.97
		Total	Part 127	Part234
	e	Production in units	500000	100000
	f=d*e	Total Profit	$4,752,156	$996,844
			A		B		C=A/B
	Part 2	Cost Pool	Total Cost	Cost Driver	Volume	CALCULATION for Volume	Overhead Rate
		Setup costs	$240,000	Number of Production Runs	300	(100+200)	$800
		Material Handling Costs	$900,000	Material Moves	900	(500+400)	$1,000
		Machine Cost	$1,750,000	Machine Hours	185000	(125000+60000)	$9
		Receiving Cost	$2,100,000	Receiving Orders	1400	(400+1000)	$1,500
		Enginnering Costs	$1,500,000	Engineering hours	10000	(5000+5000)	$150
		General Plant Cost	$500,000	Direct labor hour	272500	(250000+22500)	$2
		Total	$6,990,000
	Part3	Computation of Overhead and Gross Margin using Activity Based Costing
				PART 127			PART 234
			D	E	F=D*E	G=F/500000	H	I=D*H	J=I/100000
			Overhead Rate	Driver Volume	Allocation	Cost per unit	Driver Volume	Allocation	Cost per unit
		Setup costs	$800	100	$80,000	$0.16	200	$160,000	$1.60
		Material Handling Costs	$1,000	500	$500,000	$1.00	400	$400,000	$4.00
		Machine Cost	$9	125000	$1,182,432	$2.36	60000	$567,568	$5.68
		Receiving Cost	$1,500	400	$600,000	$1.20	1000	$1,500,000	$15.00
		Enginnering Costs	$150	5000	$750,000	$1.50	5000	$750,000	$7.50
		General Plant Cost	$2	250000	$458,716	$0.92	22500	$41,284	$0.41
				Total	$3,571,148	$7.14	Total	$3,418,852	$34.19
			Part127	Part234
		Overhead/Unit	$7.14	$34.19
		Gross Margin:
	a	Selling Price /Unit	$31.86	$24.00
	b	Prime costs/unit	$9.53	$8.26
	c	Overhead/Unit	$7.14	$34.19
	d=a-b-c	Gross Margin/unit	$15.19	($18.45)
		Total	Part 127	Part234
	e	Production in units	500000	100000
	f=d*e	Total Profit	$7,593,852	($1,844,852)