Question

"Two dollars of gross margin per briefcase? That's ridiculous!" roared Roy Thurmond, president of First-Line Cases, Inc. "Why do we go on producing those standard briefcases when we’re able to make over $10 per unit on our specialty items? Maybe it’s time to get out of the standard line and focus the whole plant on specialty work." Mr. Thurmond was referring to a summary of unit costs and revenues that he had just received from the company’s accounting department: Standard Briefcases Specialty Briefcases Selling price per unit $ 26.85 $ 42.70 Unit product cost 24.85 32.16 Gross margin per unit $ 2.00 $ 10.54 FirstLine Cases produces briefcases from leather, fabric, and synthetic materials in a single plant. The basic product is a standard briefcase that is made from leather lined with fabric. The standard briefcase is a high-quality item and has sold well for many years. Last year, the company decided to expand its product line and produce specialty briefcases for special orders. These briefcases differ from the standard in that they vary in size, they contain the finest leather and synthetic materials, and they are imprinted with the buyer’s name. To reduce labor costs on the specialty briefcases, automated machines do most of the cutting and stitching. These machines are used to a much lesser degree in the production of standard briefcases. "I agree that the specialty business is looking better and better," replied Beth Mersey, the company's marketing manager. "And there seems to be plenty of demand out there, particularly because the competition hasn't been able to touch our price. Did you know that Velsun Company, our biggest competitor, charges over $50 a unit for its specialty items? Now that’s what I call gouging the customer!" A breakdown of the manufacturing cost for each of FirstLine Cases’ products is given below: Standard Briefcases Specialty Briefcases Units produced each month 20,000 3,500 Direct materials: Leather $ 8.20 $ 12.20 Fabric 2.20 1.20 Synthetic 0 7.20 Total materials 10.40 20.60 Direct labor (0.50 DLH and 0.40 DLH @ $12.20 per DLH) 6.10 4.88 Manufacturing overhead (0.5 DLH and 0.4 DLH @ $16.70 per DLH) 8.35 6.68 Total cost per unit $ 24.85 $ 32.16 Manufacturing overhead is applied to products on the basis of direct labor-hours. The rate of $16.70 per hour was determined by dividing the total manufacturing overhead cost for a month by the direct labor-hours: Predetermined overhead rate = Manufacturing overhead = $190,380 = $16.70 per DLH Direct labor-hours 11,400 DLHs The following additional information is available about the company and its products: a. Standard briefcases are produced in batches of 1,000 units, and specialty briefcases are produced in batches of 100 units. Thus, the company does 20 setups for the standard items each month and 35 setups for the specialty items. A setup for the standard items requires one hour, whereas a setup for the specialty items requires two hours. b. All briefcases are inspected to ensure that quality standards are met. Each month a total of 200 hours is spent inspecting the standard briefcases and 300 hours is spent inspecting the specialty briefcases. c. A standard briefcase requires 0.6 hours of machine time, and a specialty briefcase requires 1.3 hours of machine time. d. The company is considering the use of activity-based costing as an alternative to its traditional costing system for computing unit product costs. The activity-based costing system has already been designed and costs have been allocated to the activity cost pools. The activity cost pools and activity measures are detailed below: Activity Cost Pool Activity Measure Estimated Overhead Cost Purchasing Number of orders $ 9,900 Material handling Number of receipts 25,200 Production orders and setups Setup-hours 14,400 Inspection Inspection-hours 21,100 Frame assembly Assembly-hours 13,860 Machine-related Machine-hours 105,920 $ 190,380 Expected Activity Activity Measure Standard Briefcases Specialty Briefcases Total Number of orders: Leather 60 20 80 Fabric 80 30 110 Synthetic material 0 140 140 Number of receipts: Leather 65 20 85 Fabric 80 30 110 Synthetic material 0 225 225 Setup-hours ? ? ? Inspection-hours 200 300 500 Assembly-hours 720 820 1,540 Machine-hours ? ? ? Required: 1. Using activity-based costing, determine the amount of manufacturing overhead cost that would be assigned to each standard briefcase and each specialty briefcase. 2. Using the data computed in part (1) above and other data from the case as needed, determine the unit product cost of each product line from the perspective of the activity-based costing system. 3. Within the limitations of the data that have been provided, evaluate the president’s concern about the profitability of the two product lines.

Answer 1

1.

Activity	Cost Driver	Cost	Volume of Cost Driver	Activity Rate	Standard	Specialty	Standard	Specialty
Purchasing	Number of Orders	$ 9,900	250	$ 39.60 per Order	140	110	5,544	4,356
Materials Handling	Number of Receipts	25,200	420	$ 60 per Receipt	145	275	8,700	16,500
Production and Setups	Setup Hours	14,400	90	$ 160 per Setup Hour	20	70	3,200	11,200
Inspection	Inspection Hours	21,100	500	$ 42.20 per Inspection Hour	200	300	8,440	12,660
Frame Assembly	Assembly Hours	13,860	1,540	$ 9 per Assembly Hour	720	820	6,480	7,380
Machine Related	Machine Hours	105,920	16,550	$ 6.40 per MH	12,000	4,550	76,800	29,120
Totals		$ 190,380					$ 109,164	$ 81,216
Units Produced							20,000	3,500
MOH per Unit							$ 5.46	$ 23.20

2.

	Standard	Speciality
Direct Materials	$ 10.40	$ 20.60
Direct Labor	6.10	4.88
Manufacturing Overhead	5.46	23.20
Unit Product Cost	$ 21.96	$ 48.68

3. Using activity based costing the actual margin on the standard line of brief cases is $ 4.89 ( $ 26.85 - $ 21.96) and not $ 2 as currently envisaged. This means that the standard line results in a gross margin of $ 4.89 x 20,000 units = $ 97,800.

On the other hand, it is actually losing money on the specialty line of brief cases at the rate of $ 5.98 per unit. Therefore, the total gross loss from the specialty line is 3,500 x 5.98 = $ 20,930.

Therefore, the management should look at increasing the price of the specialty line enough to cover manufacturing costs and operating expenses, or should discontinue the line.