Question

INDIRECT COST ANALYSIS OF MEDICAL EQUIPMENT MANUFACTURING COSTS

Background

A portable sterilizing unit, PS6, was introduced recently to the market. It utilizes nitrogen dioxide (NO₂) gas as the sterilant. This unit sterilizes and makes available at the bedside some of the reusable instruments that nurses and doctors usually obtain by walking to or receiving delivery from a centralized area. The PS6 unit makes the instruments available at the point and time of use for burn and severe wound patients who are in a regular patient room.

There are two models of PS6 available. The standard version sells for $10.75, and a premium version with customized trays and a battery backup system sells for $29.75. The product has sold well to hospitals, convalescent units, and nursing homes at the level of about 1 million units per year.

Information

The manufacturer, Health Care Services, has historically used an indirect cost allocation system based upon direct hours to manufacture for all its other product lines. The same was applied when PS6 was priced. However, Arnie, the

person who performed the indirect cost analysis and set the sales price, is no longer at the company, and the detailed analysis is no longer available. Through e-mail and telephone conversations, Arnie said the current price was set at about 10% above the total manufacturing cost determined 2 years ago, and that some records were available in the design department files. A search of these files revealed the manufacturing and cost information in Table 15–11. It is clear from these and other records that Arnie used traditional indirect cost analysis based on direct labor hours to estimate the total manufacturing costs of $9.73 per unit for the standard model and $27.07 per unit for the premium model.

Last year management decided to place the entire plant on the ABC system of indirect cost allocation. The costs and sales figures collected for the PS6 line the year before were still accurate. Five activities and their cost drivers were identified for the Health Care Services manufacturing operations (Table 15–12). Also, the volumes for each model are summarized in this table.

The ABC method will be used henceforth, with the intention of determining the total cost and price based on its results.

TABLE 15–11	Historical Records of Direct and Indirect Cost Analyses for PS6
PS6 Direct Cost (DC) Evaluation
Model	Direct Labor, $/Unit1	Direct Material, $/Unit	Direct Labor, Hours/Unit	Total Direct Labor Hours
Standard	5.00	2.50	0.25	187,500
Premium	10.00	3.75	0.50	125,000
PS6 Indirect Cost (IDC) Evaluation
Model	Direct Labor, Hours/Unit	Fraction IDC Allocated	Allocated IDC, $	Sales, Units/Year
Standard	0.25	1313	1.67 million	750,000
Premium	0.50	2323	3.33 million	250,000
1Average direct labor rate is $20 per hour.

TABLE 15–12	PS6 Activities, Cost Drivers, and Volume Levels for ABC-Based Indirect Cost Allocation
Activity	Cost Driver	Volume/Year	Actual Cost, $/Year
Quality	Inspections	20,000 inspections	800,000
Purchasing	Purchase orders	40,000 orders	1,200,000
Scheduling	Change orders	1,000 orders	800,000
Production setup	Setups	5,000 setups	1,000,000
Machine operations	Machine hours	10,000 hours	1,200,000
	Volume Level for the Year
Cost Driver	Standard	Premium
Quality inspections	8,000	12,000
Purchase orders	30,000	10,000
Number of change orders	400	600
Production setup	1,500	3,500
Machine hours	7,000	3,000

Question:

If the prices and number of units sold are the same next year (750,000 standard and 250,000 premium), and all other costs remain constant, compare the profit from PS6 under the ABC method with the profit using the traditional indirect cost allocation method.

Answer 1

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Profit as per Traditional Method:
		Standard	Premium	Total
Sales Value		$             8,062,500	$             7,437,500	$       15,500,000
750000*10.75
250000*29.75
Less: Direct Cost
Direct Labor
750000*5		$             3,750,000	$             2,500,000	$         6,250,000
250000*10
Direct Material
750000*2.5		$             1,875,000	$                 937,500	$         2,812,500
250000*3.75
Less: Indirect Cost		$             1,670,000	$             3,330,000	$         5,000,000
Net Income		$                767,500	$                 670,000	$         1,437,500
Profit as per ABC Method:
		Standard	Premium	Total
Sales Value		$             8,062,500	$             7,437,500	$       15,500,000
750000*10.75
250000*29.75
Less: Direct Cost
Direct Labor
750000*5		$             3,750,000	$             2,500,000	$         6,250,000
250000*10
Direct Material
750000*2.5		$             1,875,000	$                 937,500	$         2,812,500
250000*3.75
Less: Indirect Cost	Working below	$             2,680,000	$             2,320,000	$         5,000,000
Net Income/(Loss)		$               -242,500	$             1,680,000	$         1,437,500
Indirect Cost as per ABC:
		A	B	B/A
Activity	Cost Driver	Volume/Year	Actual Cost, $/Year	Cost per Activity
Quality	Inspections	20,000 inspections	$                 800,000	$                     40
Purchasing	Purchase orders	40,000 orders	$             1,200,000	$                     30
Scheduling	Change orders	1,000 orders	$                 800,000	$                   800
Production setup	Setups	5,000 setups	$             1,000,000	$                   200
Machine operations	Machine hours	10,000 hours	$             1,200,000	$                   120
	C	D	D*C	E	C*E
Cost Driver	Cost per Activity	Standard	IDC - Standard	Premium	IDC-Premium
Quality inspections	$                      40	8,000	$                 320,000	12,000	$      480,000
Purchase orders	$                      30	30,000	$                 900,000	10,000	$      300,000
Number of change orders	$                    800	400	$                 320,000	600	$      480,000
Production setup	$                    200	1,500	$                 300,000	3,500	$      700,000
Machine hours	$                    120	7,000	$                 840,000	3,000	$      360,000
Total			$             2,680,000		$   2,320,000
Comparison:
	ABC	Traditional
Standard	$            -242,500	$                767,500
Premium	$          1,680,000	$                670,000