To help illustrate the source of these distortions to senior management, Peterzon decided to develop a simple four-product model. He decided it would be helpful if the actual production costs of the four products were known a priori (see Table A).
A | B | C | D | |
Material cost | 15 | 5 | 10 | 5 |
Direct labor | 30 | 5 | 15 | 10 |
Variable overhead | 15 | 7.5 | 5 | 7.5 |
Variable Cost | 60 | 17.5 | 30 | 22.5 |
Fixed Cost | 10 | 10 | 12,500 | 12,500 |
Product lines A and B used identical equipment that could each
produce 1,000 units of A
or B. Product lines C and D used identical equipment that could
each produce 1,000 units of C or D.
He then calculated the direct labor allocation rate that the
existing single burden rate cost system would generate assuming
that each product sold a thousand units, the maximum that could be
produced, and that each direct labor hour cost $5. Under this
scenario, the costs incurred would be:
Variable Product Overhead | Labor Hours Per Unit | Variable Overhead/unit | No. Units | Total Labor Hours | Total |
A | 6 | 15 | 1 | 6 | 15 |
B | 1 | 7.5 | 1 | 1 | 7.5 |
C | 3 | 5 | 1 | 3 | 5 |
D | 2 | 7.5 | 1 | 2 | 7.5 |
Total | 4 | 12 | 35 |
and the new allocation rate:
Variable overhead | 35,000 |
Fixed Overhead | 45,000 |
Total Cost to be Allocated | 80,000 |
Labor Hours ($60,000/5) | 12,000 |
Allocation rate/hour | $6.67 |
Using this allocation rate per hour, Peterzon calculated the
standard cost of the four products.
Product | A | B | C | D |
Material | 15 | 5 | 10 | 5 |
Labor | 30 | 5 | 15 | 10 |
Allocated Cost | 40 | 6.67 | 20 | 13.33 |
Standard Cost | $85 | 16.67 | 45 | 28.34 |
If the firm set out to make a 40% mark-on,b then it would want to charge the following prices for the four products:
Product | A | B | C | D |
Standard Cost | 85 | 16.67 | 45 | 28.34 |
40% Mark-on | 34 | 6.67 | 18 | 11.34 |
Selling Price | $119 | 23.34 | 63 | 39.68 |
Mark-on % = profit/cost
If industry selling prices were established using actual production costs and a 40% mark-on, they would be:
Product | A | B | C | D |
Standard Cost | 70 | 27.5 | 42.5 | 35 |
40% Mark-on | 28 | 11 | 17 | 14 |
Selling Price | $98 | 38.5 | 59.5 | 49 |
By comparing the "industry" prices to the firm's costs and assuming
that the firm had to match industry prices, Peterzon could
determine which products would appear profitable.
Selling Price | 98 | 38.5 | 59.5 | 49 |
Standard Cost | 85 | 16.67 | 45 | 28.34 |
Profit | 13 | 21.83 | 14.5 | 20.66 |
Markup | 15% | 131% | 32% | 73% |
CCI had recently adopted a policy of discontinuing all products whose mark-ons were under 25%. Under this policy, product A would be dropped and additional product B manufactured. Assuming the firm could sell all of product B that it could manufacture, then the sales would be
Budgeted | A | B | C | D |
Current Volume | 1,000 | 1,000 | 1,000 | 1,000 |
Actual Volume | 0 | 2,000 | 1,000 | 1,000 |
The unused production capacity was used to produce an additional 1,000 units of B.
The resulting product mix was so different from the starting mix that Peterzon decided to recalculate the allocation rate per hour to determine if it had been affected:
Costs Incurred ($ thousand)
Variable Product Overhead | Labor Hours/Unit | Variable Overhead/ Unit | No. Units | Total Labor Hours | Total |
B | 1 | 7.5 | 2,000 | 2,000 | 15,000 |
C | 3 | 5 | 1,000 | 3,000 | 5,000 |
D | 2 | 7.5 | 1,000 | 2,000 | 7,500 |
Total | 4,000 | 7,000 | 27,500 |
and the new allocation rate:
Variable Overhead : 27,500
Fixed Overhead: 45,000
72,500
Labor Hours ( 35,000/5) : 7,000
Allocation rate/hour: $10.36
Q1) What will CCI now have to charge for each product to make 40% mark-on? If CCI maintains its rule about dropping products with a mark-on below 25%, which additional products, if any, will it drop?
Variable cost per product ( $ per unit) |
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A |
B |
C |
D |
|
Material Cost |
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Direct Labor |
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Variable overhead |
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Variable cost |
Standard costs ($) |
A |
B |
C |
D |
Material Cost |
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Direct Labor |
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Variable Overhead allocation |
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Fixed overhead allocation |
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Standard full cost |
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Selling price based on actual costs with 40% mark on (given in the case) |
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Selling price based on standard costs with 40% mark on (given in the case) |
Analysis table |
A |
B |
C |
D |
Mark on % (actual cost based selling price-standard full cost)/standard full cost) |
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contribution margin (actual cost based selling price-variable cost) |
Based on above analysis which product(s) will drop off? Why? Explain briefly
Based on above fill out the table below for total production and sale ($):
Do not fill out the column for dropped off product.
Gross profitability table based on production |
A |
B |
C |
D |
Total |
Number of units produced |
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Revenue based on actual cost price |
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Total variable cost |
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Contribution margin |
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Fixed costs |
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Gross margin |
Q2: Alternatively if the rule was to drop the product with the lowest contribution margin, which product would you drop? Please fill out the tables below for the remaining products:
Variable product overhead |
Labor hours per unit |
variable overhead/unit |
no. of units |
total labour hours |
total |
Total |
New allocation rate: |
|
variable overhead |
|
fixed overhead |
|
total cost to b allocated |
|
labor hours |
|
Allocation rate ($per hour) |
Do not fill out the column for dropped off product.
Standard costs ($) |
A |
B |
C |
D |
Material Cost |
||||
Direct Labor |
||||
Variable Overhead allocation |
||||
Fixed overhead allocation |
||||
Standard full cost |
||||
Selling price based on actual costs with 40% mark on (given in the case) |
||||
Selling price based on standard costs with 40% mark on (given in the case) |
Do not fill out the column for dropped off product.
Analysis table |
A |
B |
C |
D |
Mark on % (actual cost based selling price-standard full cost)/standard full cost) |
||||
contribution margin (actual cost based selling price-variable cost) |
Based on above analysis which product(s) will drop off? Why? Explain briefly.
Based on above fill out the table below for total production and sale ($):
Do not fill out the column for dropped off product.
Gross profitability table based on production |
A |
B |
C |
D |
Total |
Number of units produced |
|||||
Revenue based on actual cost price |
|||||
Total variable cost |
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Contribution margin |
|||||
Fixed costs |
|||||
Gross margin |
A | B | C | D | ||
Sales | 0 | 2000 | 1000 | 1000 | |
No of labor hours per unit | 0 | 1 | 3 | 2 | |
Total labor hours | 2000 | 3000 | 2000 | 7000 | |
Variable overhead per unit | 7.5 | 5 | 7.5 | ||
Variable overhead costs total | 15000 | 5000 | 7500 | 27500 | |
Fixed overhead | 45000 | ||||
Total overheads | 72500 | ||||
Hours | 7000 | ||||
Overhead rate | 10.35714 |
Standard costs | ||||
A | B | C | D | |
Material costs | 5 | 10 | 5 | |
Direct labor | 5 | 15 | 10 | |
Allocated overhead | 10.35 | 31.05 | 20.7 | |
Standard costs | 20.35 | 56.05 | 35.7 | |
40% Mark-up | 8.14 | 22.42 | 14.28 | |
Selling Price | 28.49 | 78.47 | 49.98 |
Actual costs | ||||
A | B | C | D | |
Material costs | 5 | 10 | 5 | |
Direct labor | 5 | 15 | 10 | |
Variable | 7.5 | 5 | 7.5 | |
Fixed | 10 | 12.5 | 12.5 | |
Actual costs | 27.5 | 42.5 | 35 | |
40% Mark-up | 11 | 17 | 14 | |
Selling Price | 38.5 | 59.5 | 49 |
Gross Profitability Table | Product A dropped off | |||
A | B | C | D | |
No of units produced | 2000 | 1000 | 1000 | |
Price | 38.5 | 59.5 | 49 | |
Revenue | 77000 | 59500 | 49000 | |
Material costs | 10000 | 10000 | 5000 | |
Direct labor | 10000 | 15000 | 10000 | |
Variable overheads | 15000 | 5000 | 7500 | |
Total variable costs | 35000 | 30000 | 22500 | |
Contribution Margin | 42000 | 29500 | 26500 | |
Fixed costs | 20000 | 12500 | 12500 | |
Gross Margin | 22000 | 17000 | 14000 | |
Based on contribution margin no product will be dropped off |
Gross Profitability Table | Product A and C dropped off | |||
A | B | C | D | |
No of units produced | 2000 | 0 | 2000 | |
Price | 38.5 | 59.5 | 49 | |
Revenue | 77000 | 0 | 98000 | |
Material costs | 10000 | 0 | 10000 | |
Direct labor | 10000 | 0 | 20000 | |
Variable overheads | 15000 | 0 | 15000 | |
Total variable costs | 35000 | 0 | 45000 | |
Contribution Margin | 42000 | 0 | 53000 | |
Fixed costs | 20000 | 0 | 25000 | |
Gross Margin | 22000 | 0 | 28000 | |
Product A and C dropped off |
Product A dropped off | |||||
Sales | 0 | 2000 | 0 | 1000 | |
No of labor hours per unit | 0 | 1 | 2 | ||
Total labor hours | 2000 | 2000 | 4000 | ||
Variable overhead per unit | 7.5 | 7.5 | |||
Variable overhead costs total | 15000 | 7500 | 22500 | ||
Fixed overhead | 45000 | ||||
Total overheads | 67500 | ||||
Hours | 4000 | ||||
Overhead rate | 16.875 |
Standard costs | ||||
A | B | C | D | |
Material costs | 5 | 5 | ||
Direct labor | 5 | 10 | ||
Allocated overhead | 16.875 | 33.75 | ||
Standard costs | 26.875 | 48.75 | ||
40% Mark-up | 10.75 | 19.5 | ||
Selling Price | 37.625 | 68.25 |
Actual costs | ||||
A | B | C | D | |
Material costs | 5 | 5 | ||
Direct labor | 5 | 10 | ||
Variable | 7.5 | 7.5 | ||
Fixed | 10 | 12.5 | ||
Actual costs | 27.5 | 35 | ||
40% Mark-up | 11 | 14 | ||
Selling Price | 38.5 | 49 |
Selling Price | 38.5 | 49 | ||
Standard costs | 26.875 | 48.75 | ||
Profit | 11.625 | 0.25 | ||
% Profit | 43% | 1% | ||
Variable costs | 17.5 | 22.5 | ||
Contribution Margin | 21 | 26.5 | ||
% | 120% | 118% | ||
Based on Mark-up product D will be droped off |
Gross Profitability Table | Product A and CD dropped off | |||
A | B | C | D | |
No of units produced | 2000 | 0 | 0 | |
Price | 38.5 | 59.5 | 49 | |
Revenue | 77000 | 0 | 0 | |
Material costs | 10000 | 0 | 0 | |
Direct labor | 10000 | 0 | 0 | |
Variable overheads | 15000 | 0 | 0 | |
Total variable costs | 35000 | 0 | 0 | |
Contribution Margin | 42000 | 0 | 0 | |
Fixed costs | 45000 | 0 | 0 | |
Gross Margin | -3000 | 0 | 0 |
If either of product C or D are dropped off there would be unutilised capacity which will generate additional fixed costs, unless and untill there is a positive contribution margin of any product the company shall continue the same to cover all the fixed costs
All the products have positive contribution margin hence, to maximize returns no product shall be dropped according to contribution margin method
To help illustrate the source of these distortions to senior management, Peterzon decided to develop a...
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