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	$	28.05		$	43.10
Unit product cost		26.05			33.08
Gross margin per unit	$	2.00		$	10.02

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 $49 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		10,000			2,500
Direct materials:
Leather	$	8.60		$	12.60
Fabric		2.60			1.00
Synthetic		0			7.60
Total materials		11.20			21.20
Direct labor (0.50 DLH and 0.40 DLH @ $12.60 per DLH)		6.30			5.04
Manufacturing overhead (0.5 DLH and 0.4 DLH @ $17.10 per DLH)		8.55			6.84
Total cost per unit	$	26.05		$	33.08

Manufacturing overhead is applied to products on the basis of direct labor-hours. The rate of $17.10 per hour was determined by dividing the total manufacturing overhead cost for a month by the direct labor-hours:

Predetermined overhead rate	=	Manufacturing overhead	=	$102,600	=	$17.10 per DLH
		Direct labor-hours		6,000 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 10 setups for the standard items each month and 25 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 260 hours is spent inspecting the standard briefcases and 340 hours is spent inspecting the specialty briefcases.

c. A standard briefcase requires 0.5 hours of machine time, and a specialty briefcase requires 1.2 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	$	15,000
Material handling	Number of receipts		16,000
Production orders and setups	Setup-hours		6,000
Inspection	Inspection-hours		17,400
Frame assembly	Assembly-hours		16,200
Machine-related	Machine-hours		32,000
		$	102,600

	Expected Activity
Activity Measure	Standard Briefcases	Specialty Briefcases	Total
Number of orders:
Leather	50	10	60
Fabric	70	20	90
Synthetic material	0	150	150
Number of receipts:
Leather	70	10	80
Fabric	85	20	105
Synthetic material	0	215	215
Setup-hours	?	?	?
Inspection-hours	260	340	600
Assembly-hours	760	860	1,620
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.

    

• Required 1
• Required 2
• Required 3

Using activity-based costing, determine the amount of manufacturing overhead cost that would be assigned to each standard briefcase and each specialty briefcase. (Do not round intermediate calculations. Round your answers to 2 decimal places.)

	Standard Briefcases Specialty Briefcases Manufacturing overhead cost per unit

Using the data computed in requirement 1 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. (Do not round intermediate calculations. Round your answers to 2 decimal places.)

	Standard Briefcases Specialty Briefcases Unit product cost

Within the limitations of the data that have been provided, evaluate the president’s concern about the profitability of the two product lines. (Loss amounts should be indicated with a minus sign. Do not round intermediate calculations. Round your answers to 2 decimal places.)

	Standard Briefcases Specialty Briefcases Gross margin (loss) per unit

Answer 1

Workings:

					Standard Briefcases		Speciality Briefcases
Activity Cost Pool	Activity Measure	Activity Cost $	Expected Activity	Activity Overhead Rate $	Expected Activity	Activity Cost $	Expected Activity	Activity Cost $
Purchasing	Number of orders	15000	300	50.00	120	6000	180	9000
Material handling	Number of receipts	16000	400	40.00	155	6200	245	9800
Production orders and setups	Setup-hours	6000	60	100.00	10	1000	50	5000
Inspection	Inspection hours	17400	600	29.00	260	7540	340	9860
Frame assembly	Assembly-hours	16200	1620	10.00	760	7600	860	8600
Machine-related	Machine-hours	32000	8000	4.00	5000	20000	3000	12000
Total $		102600				48340		54260

1. Manufacturing overhead cost per unit

Standard: $48340/10000 = $4.834 = $4.83

Speciality: $54260/2500 = $21.704 = $21.70

2. Unit product cost using activity based costing

	Standard Briefcases	Speciality Briefcases
Direct materials	11.20	21.20
Direct labor	6.30	5.04
Manufacturing overhead	4.83	21.7
Unit product cost $	22.33	47.94

3. Gross margin (loss) per unit

	Standard Briefcase	Speciality Briefcase
Selling price per unit	28.05	43.10
Unit product cost	22.33	47.94
Gross margin (loss) per unit $	5.72	-4.84

The president's concern is due to the inappropriate assignment of overheads to the two products. Assignment of overheads on activity based costing shows that the standard briefcases are generating a higher gross margin while the speciality briefcases are running up losses. The unit product cost of speciality also justifies the price of $49 charged by Firstline's competitor. Firstline, thus needs to increase its pricing of speciality in order to avoid the losses and continue producing the standard briefcases which are generating gross margin of $5.72 per unit.