Question

Barnes Boards produces skateboard parts for six different major US skateboard manufacturers. Barnes specializes in the production of trucks, which attach the skateboard wheels to the skateboard deck and allow the rider to turn the skateboard.  Barnes Boards' trucks are made primarily of molded aluminum.  Currently, Barnes Boards produces two different types of trucks: The 700 and the 775. The 700 has the highest sales and for many years was the only truck produced by Barnes Boards. As a result of the soaring popularity of longboards the 775 was added to the Barnes Boards product line six years ago.

Relative to the 700, production of the 775 is complicated because it required special tooling and setups. Profits for Barnes Boards increased for the first three years after adding the 775. In the most recent two years, however, sales of the 700 have fallen dramatically and profits have turned to losses. Kellie Barnes, who oversees manufacturing at Barnes Boards, suspects that intense competition from foreign skateboard-part manufacturers is driving the decrease in sales. Kellie is convinced that the foreign manufacturers are trying to drive Barnes Boards out of business by selling trucks below the cost of producing them.

The following conversation between Beau Barnes, the owner of Barnes Boards, and Kellie Barnes.

BEAU:  Kellie, I can't continue to lose money manufacturing trucks. I think it may be best to shut down Barnes Boards and pursue something different. I'm not sure that we can compete anymore.

KELLIE:  Your so dramatic Beau, and you always have been. We've been making money on the 700 for decades and we haven't had to work that hard to do it. Now that we have to actually work to correct a problem you want to shut down the business. Give me a break.

BEAU: Ha! Maybe you're right, but I just got off the phone with Joan over at Elephant Boards, our biggest customer, and she said that she was offered a truck that is pretty much identical to the 700 for $20 per unit. That's $11 less than what we charge them! That's impossible to compete with...I think our manufacturing processes are simply out of date, and I don't know if we can catch up.

KELLIE: That's not it, Beau! I would put our manufacturing efficiency up against any production floor in the world. We have competitive technology and hard workers and we're operating in a nice labor market. It's costing us about $21 to produce the 700. Our competition isn't able to produce the part for less than us. They're just selling the part below cost to get rid of us! We shouldn't sell the 700 for $20. What we should do is focus on producing more and selling more of the 775, where the margin is high and the competition is low.

BEAU:  Actually, you may be right. I asked Joan if Elephant would be willing to pay 25% more for the 775's and she said that they probably would pay more for the 775. Joan also seems to think that most skateboard makers would pay more for the 775 and still buy the same amount from us.

KELLIE:  Okay then I think we can find a way out of this, but before we make any major commitments to the 775, we should explore some other possible explanations for the price difference. I want to know for sure whether or not our production is efficient. If we can find a way to improve efficiency, then maybe we can get back to a reasonable margin on the 700. The market for the 700 is so much bigger. If we can find a way to make the 700 profitable, then that would be good because I'm not sure that we can survive on the 775 alone. Also, everyone hates working on the 775 because it's a real pain to set it up and push it through the process.

BEAU:  Okay Kellie, I'm interested in what you come up with. I know you think that I'm being dramatic, but I'm seriously concerned about the future of Barnes Boards and our ability to keep going in this environment. This could be the end. I'll tell the people over in accounting to be expecting your call. I'll tell them put our best cost accountant on this to help you understand the situation.

After the conversation, Kellie comes to you for help and you are able to quickly put together the following summary information for the two products (based on the most recent year).

	700	775
Production (units)	500,000	100,000
Selling price	$31.86	$24.00
Prime Cost / u	$8.53	$6.26
Overhead / u	$12.83	$5.77
Total direct labor hours (used to assign $6,990,000 in total overhead)	250,000	22,500

Requirement 1: Before sharing the report, you want to verify the overhead cost per unit calculation. Create a note that provides the details of these calculations.

Requirement 2: Compose a professional e-mail to Kellie. In the e-mail, communicate what the gross profit per unit is based on the information above. Also introduce Kellie to the basics of activity based costing and why it may be more useful than the current cost system in this setting. In your e-mail, ask Kellie if she can provide estimates for the numbers below (based on the most recent year) and explain to her how these numbers can be used to arrive at more accurate product costs related to setups, machining, and materials handling.

a) The number of production runs for each product.

b) The number of machine hours used on each product.

c) The number of material moves related to each product.

Additional Information: Assume that Kellie provides the following estimates:

	700	775
Production runs	100	200
Machine hours	125,000	60,000
Material moves	500	400

In addition, assume that you develop the following estimates from other sources (e.g., the accounting systems and conversations with others at Barnes Boards):

	700	775
Receiving orders	400	1,000
Engineering hours	5,000	5,000

Together, this information will be useful in determining product costs based on what you propose are the five fundamental drivers of cost at Barnes Boards: (1) setup costs, (2) machine costs, (3) materials-handling costs, (4) receiving costs, and (5) engineering costs. When you classify overhead costs in the accounting system by major activity, you arrive at the following costs for each activity for the most recent year.

Overhead
Setup costs	$240,000
Machine costs	$1,750,000
Receiving costs	$2,100,000
Engineering costs	$2,000,000
Materials handling costs	$900,000
Total	$6,990,000

Requirement #3: Prepare a table (or tables) in Microsoft Word that shows the per unit product cost and gross profit for each product using the traditional system and the activity based costing system. Provide the cost by activity for the activity based costing portion. Based on the information in the table(s), provide written commentary that addresses the following:

3a- Should Barnes Boards switch its focus to the 775? Why or why not?

3b- Is it likely that foreign competitors are making a profit selling the truck similar to the 700 for $20?

3c- Elephant boards is willing to pay more for the 775 and Barnes Boards sees little competition to the 775's. How does the activity based costing system help to explain this?

3d- What action should be taken to make Barnes Boards profitable?

Answer 1

Sol.

1 Overhead cost per unit using direct labor hours to assign overhead. Total Overheads (a) 6,990,000.00 Direct labor hours (b) 272,500.00 =250000+22500 Overhead rate c=(a/b) $ 25.65 Part 700 Part 775 Particulars Direct labor hours (d) Production (e) Direct labor hours per unit (f=d/e) Overhead cost per unit (g*25.65) 250,000.00 500,000.00 0.50 22,500.00 100,000.00 0.225 S 12.83 $ 5.77 2 E-mail to ellie Dear Kellie, In the current system Gross profit per unit is based on the overhead allocated based on Direct labor hours. This is not a correct system in modern scenario where there are multiple cost which are incurred based on various activities incurred for the product. The costing system used in modern era is called Activity Based Costing. In Activity based costing Cost are apportioned based on activity based on which costs are incurred (instead of a single overhead rate based on labour). It is more useful than the current cost system in this setting. If you can provide estimates for the numbers below (based on the most recent year), it will be helpful as these numbers can be used to arrive at more accurate product costs related to setups, machining, and materials handling. a) The number of production runs for each product. b) The number of machine hours used on each product. c) The number of material moves related to each product. Regards, XXX

100,000 $24.00 3 Per-unit cost and gross profit for each product using Traditional systems Particulars Part 700 Part 775 Production 500,000 Selling price (a) $31.86 Cost: Overhead per unit (b) $ 12.83 $ Prime cost per unit (c) $8.53 Total Cost per unit (d =b+c) $21.36 Gross margin per unit (a-d) $10.50 Gross Profit for each product 5,252,155.96 5.77 $6.26 $12.03 $11.97 1,196,844.04

Activity based costing Rate per Overhead: Setup costs Machine costs Receiving costs Engineering costs Materials-handling costs Total Overhead Cost (1) Units (g) Total Overhead Cost per unit (f/g) Part 700 Part 775 Total Part 700 Cost Part 775 Cost Cost (d) Cost Driver Activities Activities Activities Activity (e=d/c) leta) le*b) (a) (b) (c=a+b) $ 240,000.00 Number of production rur 100 200 300 $ 800.00 $ 80,000.00 $ 160,000.00 $ 1,750,000.00 Machine hours 125,000 60,000 185,000 $ 9.45 $1,182,432.43 $ 567,567.57 $ 2,100,000.00 Receiving orders 400 1000 1400 $ 1,500.00 $ 600,000.00 $1,500,000.00 $ 2,000,000.00 Engineering hours 5,000 5,000 10,000 $ 200.00 $1,000,000.00 $1,000,000.00 $ 900,000.00 Material moves 500 400 9000 $ 1,000.00 $ 500,000.00 $ 400,000.00 $ 6,990,000.00 3,362,432.43 3,627,567.57 500,000 100,000 6.72 36.28 100,000 $24.00 Per-unit cost and gross profit for each product using Activity based costing Particulars Part 700 Part 775 Production 500,000 Selling price (a) $31.86 Cost: Overhead per unit (b) 6.72 Prime cost per unit (c) $8.53 Total Cost per unit (d =b+c) $15.25 Gross margin per unit (a-d) $16.61 Gross Profit for each product 8,302,567.57 36.28 $6.26 $42.54 -$18.54 (1,853,567.57)

3a Should the company switch its emphasis from the high-volume product to the low-volume product Particulars Part 700 Part 775 Current Gross margin per unit $16.61 $18.54 The company should not switch its emphasis from the high-volume product(Part700) to the low-volume product (Part 775) as Gross margin per unit using Activity based Costing is negative 3b Is it likely that foreign competitors are making a profit selling the truck similar to the 700 for $20? It is likely that foreign competitors are making a profit selling the trucksimilar to the 700 for $20 as Coorect Cost per unit for Part 700 id $10.50. and by Selling at $20, they are making profit of $9.50 per unit

3c Elephant boards is willing to pay more for the 775 and Barnes Boards sees little competition to the 775 Particulars Part 700 Part 775 Current Gross margin per unit $16.61 $18.54 Increase in Sale price $6.00 =259624 Revised Gross margin per unit $16.61 $12.54 If Elephant vorad is willing to pay more for 775, The company should not switch its emphasis from the high-volume product(Part700) to the low-volume product (Part 775) as Gross margin per unit is still negative

	3d	Action should be taken to make Barnes Boards profitable
		The company should not sell Part 775 at price of 24 as company is incurring loss when selling at $24. The Company should increase price of Part 775 and keep it more than 24 to earn profit. Further, company should focus more on Part 770 and even price can be reduced to be competitive