Question

Scenario

Cartech Manufacturing is engaged in the production of replacement parts for automobiles. One plant specializes in the production of two parts: Part 271 and Part 342. Part 271 produces the highest volume of activity, and for many years it was the only part produced by the plant. Five years ago, Part 342 was added. Part 342 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 271 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 Tricia Goodson, plant manager, and Jackson Fielding divisional marketing manager, reflects the concerns of the division about the future of the plant and its products.

Jackson: You know, Tricia, 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.

Tricia: Joe, you and I both know that Part 271 has a reputation for quality and value. It has been a mainstay for years. I don’t understand what’s happening.

Jackson: I just received a call from one of our major customers concerning Part 271. 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.

Tricia: 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. I don’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 342. Our margin is high on this product, and we have virtually no competition for it.

Jackson: You may be right. I think we can increase the price significantly and not lose 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.

Tricia: It sounds promising. However, before we make a major commitment to Part 342, 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 271. The market is so much bigger for this part. I’m not sure we can survive with only Part 342. Besides, my production people hate that part. It’s very difficult to produce.

After her meeting with Jackson, Tricia requested an investigation of the production costs and comparative efficiency. She received approval to hire Wake Consulting Group to make an independent investigation.

You, as the staff accountant for Wake Consulting Group, have uncovered the following costs and activities associated with the two products.

	Part 271	Part 342
Production	500,000	100,000
Selling Price	$31.86	$24.00
Prime costs per unit	$9.53	$8.26
Number of production runs	100	200
Receiving orders	400	1,000
Machine hours	125,000	60,000
Direct labor hours	250,000	22,500
Engineering hours	5,000	5,000
Material moves	500	400

Overhead is allocated using a plant-wide rage based on direct labor hours.

Preliminary analysis of costs by Wake Consulting Group revealed that similar costs can be categorized into the following cost pools. Setup costs are costs that occur each time a new production run is made. They involve retooling and reconfiguring the machines and technology. Material handling costs include the equipment and personnel required to transport materials from supplier trucks to the machines. Typically, materials are taken to a storage area before being transported to machines. Each production run will need new materials and materials may also be transported during production runs. Machine costs primarily include depreciation and machine maintenance. Although the machines are depreciated using accelerated depreciation schedules, typically the machine wear out from use and are replaced before they become obsolete. Receiving costs include the costs of clerical and technical help associated with the processing of each order received from a customer. Engineering costs include the technical support staff that implement design changes in the part, manage processes to maintain quality, and provide technical information on the product. The engineering staff maintain a record of the amount of time spent on each product. General plant costs include all the other administrative costs not included in the other cost pools.

Overhead Cost Pools
Setup costs	$240,000
Material handling costs	$900,000
Machine costs	$1,750,000
Receiving costs	$2,100,000
Engineering costs	$1,500,000
General plant costs	$500,000
Total	TOTAL :   $6,990,000 Part 1: Compute overhead and gross margin using traditional costing. Per unit Part 342 Part 271 Selling Price $ $ Product Cost Prime costs $ Overhead Total Product Cost $ Total Profit $ Part 2: Select the best cost driver and compute overhead rates for each cost pool. Overhead Rate Cost Pool Cost Driver $ Setup costs Material handling costs $ Machine costs Receiving costs $ Engineering costs General plant costs $

Answer 1

Answer

Requirement a

Per unit	Part 271	Part 342
Selling Price	$          31.86	$            24.00
Product Cost
Prime cost	$            9.53	$              8.26
Overheads (Note)	$          12.83	$              5.77
Total Product Cost	$          22.36	$            14.03
Total Profits	$            9.50	$              9.97

Requirement b

Cost Pool	Cost Driver	Overhead Rate	Calculation
Setup Costs	Number of production runs	$          800.00	$ 240,000/300
material handling cost	Material moves	$       1,000.00	$ 900,000/900
Machine costs	Machine hours	$              9.46	$ 1,750,000/185,000
Receiving costs	Receiving orders	$       1,500.00	$ 2,100,000/1,400
Engineering costs	Engineering hours	$          150.00	$ 1,500,000/10,000
General plant costs	Direct Labor Hours	$              1.83	$ 500,000/272,500

Workings for Overheads:

part 271: (($ 6,990,000 / 272,500) * 250,000) / 500,000 = $ 12.83

Part 342: (($ 6,990,000 / 272,500) * 22,500) / 100,000 = $ 5.77

In case of any doubt, please comment.