Destin Brass president Roland Guidry is concerned with the competitive trends of the company products. He and his staff are worried that company profits are falling in regards to these competitive problems. Analysis:
Destin Brass Company manufactures three items dealing with water purification systems: valves, pumps, and flow controllers. The company has been seeing some problems dealing with competition within some of the product markets they produce. Ronald Guidry had two basic questions they wanted answered dealing with this case: 1. Why was it so difficult for the company to stay competitive in the pump market? 2. Why has the company not seen any competition in the flow controller market even with a recent raise in their price to consumers? These questions aroused from Guidry when he realized that the company wasn’t making the standard 35% gross profit margin in pumps. This was the case because the company was forced to reduce the selling price in pumps away from the target price ($97.10 to $81.26) due to stiff competition. Management also realized the excessive gross profit margin of 42% in flow controllers even after a recent 12.5% increase in price. [pic]
The answer to the questions raised by management is directly related to how the company is accounting for their overhead relating to each product. The company had been using a traditional way of allocating overhead. (Exhibit 2) This was a simple and inexpensive way for the company to accomplish this task. However, it really didn’t accurately assign overhead to each product. Destin realized this and had it controller, Peggy Alford, design a revised way for allocating overhead. (Exhibit 3) This revised system didn’t seem to answer any questions or alleviate any problems that Destin was having. Activity Based Costing (ABC) was another possibility to allocate overhead and helps answer the questions above. (Exhibit 4) Traditional Cost system:
The traditional cost system that was currently being used was a fairly inexpensive way for the company to allocate overhead cost. This system was used to generate a standard unit cost that was then used to produce a target selling price based on the 35% profit margin set by the company. The structure used to assign overhead to each product to arrive at a standard cost was a very inappropriate method for the company to use. There are a number of reasons that this way was inappropriate. First, the only way overhead is allocated using this system is by assigning overhead to production to each product on the basis of production-run labor costs. [pic]
The table above shows how the overhead rate was generated for use in the traditional cost system. Using this rate it allocates $4.39 of overhead for every $1.00 of run labor used in the product which the labor was applied. This per unit overhead rate is then added with a material and direct labor per unit cost. Adding these three cost up will give you the standard unit cost for producing each product. (Exhibit 2) This system basis all overhead on labor and therefore is not a very accurate way to distribute overhead cost to each product. Take for instance the flow controllers which have a labor usage of .40 hours per unit. Using the overhead rate above of 439%, overhead allocated to each flow controller is $28.10. This only takes into account direct labor and nothing else. This creates a problem because even though Flow Controllers take .40 hours to produce they only use .20 hours of machine usage. Compare this machine usage to .50 machine hours to produce each valve which uses .25 labor hours and .50 hours to produce each pump which uses .50 labor hours. This shows that flow controllers are incurring more cost then needed when dealing with machine usage. This problem of over allocating overhead to certain products is also true when dealing with machine depreciation. Machine depreciation accounts for $270,000...
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