Question

TuTu Ltd. is a global manufacturer of engines for trucks. Because of high quality of engines, TuTu has enjoyed a decent profit margin for the past fifteen years. Due to the growing environmental concerns, TuTu expanded its core product market of traditional engines (TA-01) to include two types of engines (HB-02 and ET-03) for hybrid and electric trucks in 2016. The firm believes that the two new products have great profit potential and its competition of traditional engines may become more intense in 5 years. TuTu was most excited about entering the market for engines for electric trucks as it experienced a strong demand for ET-03. Few competitors can compete with TuTu in this market. TuTu believes that excellent quality reputation and first-mover are its competitive advantage in this new market. Although current volumes are relatively small, TuTu plans to expand this product to reach three times the current volume since there is substantial market potential for this product. However, in the beginning of 2017, TuTu was surprised of a big drop of profit margin shown in the 2016 income statement. Although the demand for traditional engines is stable, CFO of TuTu, Grace Rizzo thinks that it might have to lower prices of TA-01 by 5% or more to increase sales and stay competitive. The following table provides key information about the product lines: TUTU LTD. Income Statement (in $ millions) Year Ended December 31, 2016 TA-01 HB-02 ET-03 Sales $880 $495 $262 Total $1,637 Direct costs: Direct materials R 1 120 26 Direct labour 40 10 ? ? 360 90 1,098 Manufacturing overhead Net Income 89

Management Accounting - It would be highly appreciated if someone could aid me in approaching this problem.

Answer 1

A) Income statement based on current allocatio system i.e., allocation of overhead cost using direct labour cost

TUTU LTD Income Statement(in $ Millions)

   Year Ebnded December 31, 2016

Particulars	TA-01	HB-02	ET-03	Toatal
Sales	$880	$495	$262	$1,637
Material Cost	($200)	($120)	($40)	($360)
Labour Cost	($54)	($26)	($10)	($90)
Overhead	($658.8)	($317.2)	($122)	($1,098)
Net Income	($32.8)	$31.8	$90	$89

Working for overheads allocation:

TA-01 = [$1,098/(54+26+10)]*54 = $658.8

HB-02 = [$1,098/(54+26+10)]*26 = $317.2

ET-03 = [$1,098/(54+26+10)]*10 = $122

B) Activity Based Costing Approcah

TUTU LTD Income Statement(in $ Millions)

   Year Ebnded December 31, 2016

Activity Based Costing Approach

Particulars	TA-01	HB-02	ET-03	Toatal
Sales	$880	$495	$262	$1,637
Material Cost	($200)	($120)	($40)	($360)
Direct Labour	($54)	($26)	($10)	($90)
Overhead	($315.51)	($349.71)	($432.78)	($1,098)
Net Income	$310.49	($0.71)	($220.78)	$89

Allocation of overhead cost based on Activity Based Costing

Particulars	TA-01	HB-02	ET-03	Total
Labour Cost	189	91	35	315
Machine Related	69.21	86.51	21.27	272
Production order	10.5	42	31.5	84
First Part Inspection	18	72	54	144
Inventory Management	12	33	60	105
Receiving and Shipping	4.8	13.2	24	42
General Adinistration	12	12	12	36
Toatal	315.51	349.71	432.78	1098

Labour cost

TA-01 = [$315/(54+26+10)]*54 = 189

HB-02 = [$315/(54+26+10)]*26 = 91

ET-03 = [$315/(54+26+10)]*10 = 35

Machine Related

TA-01 = [$372/(0.16+0.2+0.5)]*0.16 = 69.21

HB-02 = [$372/(0.16+0.2+0.5)]*0.2 = 86.51

ET-03 = [$372/(0.16+0.2+0.5)]*0.5 = 216.27

Production order:

TA-01 = [$84/(5+20+15)]*5 = 10.5

HB-02 = [$84/(5+20+15)]*20 = 42

ET-03 = [$84/(5+20+15)]*15 = 31.5

First part Inspection:

TA-01 = [$144/(5+20+15)]*5 = 18

HB-02 = [$144/(5+20+15)]*20 = 72

ET-03 = [$144/(5+20+15)]*15 = 54

Inventory Management:

TA-01 = [$105/(40+110+200)]*40 = 12

HB-02 = [$105/(40+110+200)]*110 = 33

ET-03 = [$105/(40+110+200)]*200 = 60

Receiving and Shipping:

TA-01 = [$42/(40+110+200)]*40 = 4.8

HB-02 = [$42/(40+110+200)]*110 = 13.2

ET-03 = [$42/(40+110+200)]*200 = 24

C) Evaluation of Profitability of 3 Products:

TUTU Managements observations that product ET-03 is more profutable is wrong. Based on activity based costing approach product TA-01 is more profitable. Activity based costing approch is more accurate because they provie a more precise breakdown of indirect costs.

Therefore mangements decision with respect to product Et-03 is ore profitable is incorrect because traditioal method of costing does not provide accurate allocation of indirect costs.

D)Recommendations:

1.Management should concentarte on TA -01 procuct than ET-03 & HB-02 to maximise their profit

2. Reduction in price of TA-01 by 5% will surely increase the sales of TA-01

3. Production of ET-03 should be reduced so that the higher indirect cost incurred through Activity based costing approch can be avoided.

4. HB-02 is under breakeven point i.e., no loss or no profit situation. Management has to reduce its production too