1-One manager suggests changing the Overhead Allocation to Direct Material used
ID: 2602791 • Letter: 1
Question
1-One manager suggests changing the Overhead Allocation to Direct Material used instead of direct Labor.
Rebuild Exhibit 2. Which is more realistic?
2- Apply ABC costing System. Use the following activities (based on the suggestion of Mr. Khan): Direct
Labor, Machine Components, Setup machines, receive the schedule components, Provide engineering
Support, Pack and Ship products.
3- What did ABC product cost and product profitability reveal?
4- If you are hired as an external Consultant, what actions would you suggest? (in details).
EXPLAIN YOUR ANSWERS AND DISSCUS YOUR FINDINGS ( SHOW YOUR CALCULATIONS IN DETAILS ) !!!?
Adapted trom ROBERT S KAPLAN INCOM Company The decline in our profits has become intolerable The severe price cuming in pumps has dropped ourpre-ta margin to less than 3%, far below our histoncal 10% margins. Fortunately, our competitors are overlooking the opportunities for profit inflow controllers. Our recent 10% price increase in that line has been implemented without losing any businets. Robert Johnson, president of the INCOM Company, was discussing operating results in the latest month with Ahmed Khan, his controller, and John Scott, his manufactring manager. The meeting among the three was taking place in an atmosphere tinged with apprehension because competitors had been reducing prices on pumps, INCOM's major product line. Since pumps were a commodity product, Johnson had seen no altemative but to match the reduced prices to maintain volume. But the price cuts had led to declining company profits, especially in the pump line (summary operating results for the previous month March 2016, are shown in Exhibits 1 and 2). INCOM supplied products to mamfacturers of water purification equipment. The company had started with a unique design for valves that it could produce to tolerances that were better than any in the incustry Johnson quickly established a loyal customer base because of the high quality of its manufactured valves. He and Scott realized that INCOM's existing labor skills and machining equipment could also be used to produce pumps and flow controllers, products that were also purchased by its customers. They soon established a major presence in the high-volume pump product line and the more customized flow controller line. INCOMs production process started with the purchase of semi-finished components from several suppliers. It machined these parts to the required tolerances and assembled them in the company's modern manufacturing facility. The same equipment and labor were used for all three product Lines, and production rms were scheduled to match customer shipping requirements. Suppliers and customers had agreed to just-in-time deliveries, and products were packed and shipped as completed. Valves were produced by assembling four different machined components (2 components of L12 and 2 of L15). Scott had designed machines that held components in fixtures so that they could be machined automatically. The valves were standard products and could be produced and shipped in large lots. Although Scott felt several competitors could now match Johnson's quality in valves, none had tried to gain market share by cutting price, and gross margins had been maintained at a standard 35%. The manufacturing process for pumps was practically identical to that for valves. Five components G components of L12 and 2 of L14) were machined and then assembled into the final product. The pumps were shipped to inchustrial product distibutors after assembly. Recently, it seemed as if each month brought new reports of reduced pnces for pumps. INCOM had matched the lower prices so that it would not give up its place as a major pump supplier. Gross margins on pump sales in the latest month had fallen below 20%, well below the company's planned gross margin of 35%. Flow controllers were devices that controlled the rate and direction of flow of chemicals. They required more components and more labor, than pumps or valves, for each finished unit. Each Flow controller required 4 components of L16, 5 components of L12 and 1 component of L21. Also, there was much more variety in the types of flow controllers used in industry, so many more production runs and shipments were performed for this product line than for valves. NCOM had recently raised flow controller prices by more than 10% with no apparent effect on demand.Explanation / Answer
Answer 1
factory payroll, this was an inexpensive way to allocate overhead costs to product, which is not the relevant reasoning for allocating cost.
Answer 1
Exhibit 2- Product Profitability Analysis (March 2016) (Amount in $) Valves Pumps Flow Controllers Direct Labour Cost 10 12.5 10 Direct Material Cost 16 20 22 Manufacturing Overhead (@176% Of direct material) 28.16 35.2 38.72 Standard Unit Cost 54.16 67.7 70.72 Target Selling Price $86.15 $107.69 $95.38 Planned Gross Margin 35% 35% 35% Actual Selling Price $86 $87 $105 Actual Gross Margin 37% 22% 33% Working Notes Calculation of Rate at which overheads will be allocated as per Direct material Total manufacturing overhead $806,000 Total Direct material Cost $458,000 Rate 176% Explanation Allocating on the basis of direct material is more realistic because in all the three components same equipment and labor were same and also direct labor was being used only because direct labor cost had to be recorded anyway to preparefactory payroll, this was an inexpensive way to allocate overhead costs to product, which is not the relevant reasoning for allocating cost.
Answer 2 ABC Costing Statement of Cost Drivers and Rate Cost Amount Cost Driver Number Rate Machine related costs $336,000 Machine Hours 11200 $30 Setup labor $40,000 No of production runs 160 $250 Receiving and Production costs $180,000 No of production runs 160 $1,125 Engeneering costs $100,000 Hours of engineering work 1250 $80 Packaging and Shipping $150,000 No of shippments 300 $500 Total $806,000 Statement of allocation of overhead cost (Amunt in $) Cost Valves Pumps Flow Controllers Total Machine related costs 112,500 187,500 36,000 336,000 (30 X 3750) (30 X 6250) (30 X 1200) Setup labor 2,500 12,500 25,000 40,000 (250 X 10) (250 X 50) (250 X 100) Receiving and Production costs 11,250 56,250 112,500 180,000 (1125 X 10) (1125 X 50) (1125 X 100) Engeneering costs 20,000 30,000 50,000 100,000 (80 X 250) (80 X 375) (80 X 625) Packaging and Shipping 5,000 35,000 110,000 150,000 (500 X 10) (500 X 70) (500 X 220) Total overhead 151,250 321,250 333,500 No of units 7,500 12,500 4,000 Overhead per unit 20.17 25.70 83.38 Answer 3 Product Profitability Analysis as per ABC Valves Pumps Flow Controllers Direct Labour Cost 10.00 12.50 10.00 Direct Material Cost 16.00 20.00 22.00 Manufacturing Overhead 20.17 25.70 83.38 Standard Unit Cost 46.17 58.20 115.38 Target Selling Price $86.15 $107.69 $95.38 Planned Gross Margin 35% 35% 35% Actual Selling Price $86 $87 $105 Actual Gross Margin 46% 33% -10% When we are allocating overheads as per ABC, it has been found that company is incurring losses on sale of flow controllers but sale of valves is reflecting gross margin higher than valves. Sale of pumps is Refelecting gross margin only 2% less than planned gross margin. Answer 4 If I am hired as an external consultant, I would suggest to use ABC costing system because it reflects the actual picture. ABC is more accruate way of calculating profits. The profitability picture that emerges from the ABC analysis helps managers focus their attention and energy on improving activities that will have the biggest impact on the bottom line.Related Questions
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