Product Gross Margin Calculation vs. Product Contribution Margin Calculation Assigning the overhead costs to the products shows how profitable the products are after deducting all cost. However, it is important to find the appropriate method of overhead cost allocation. In Sippican’s case the traditional accounting method is used, which does not reflect the real resource usage of the different product lines. The correct method in this case would be to apply the time-driven ABC approach for cost allocation. Such method apart from showing the actual profitability after all cost deductions also depicts the differences in resource usage rates between the products and, thus, allows for identification of cost drivers. A contribution margin approach provides only insight into the products profitability after variable cost deduction, but it does not show whether the profit of a particular product is still profitable after all cost deductions. This could lead to a false perception of product profitability. In addition, this approach could lead to wrong decision making in terms of pricing or expansion actions. Moreover, with this approach it is not possible to identify any cost drivers. Thus, many profitability improvement opportunities might be lost. Moreover, in particular, in the Sippican’s case the overhead costs are not really fix. They are fix only in the short term but variable in the long term as with an increase in volume of the products or the number of various products more machines and labor are required. The correct term for such cost is step-fix cost. Thus, the overhead costs in this case are not really a period expense (only in the short term). Thus, the volume of each product line does indirectly drive the overhead cost in the long term. Consequently, it is important to see how each product affects the overhead costs or, to say it the other way around, what amount of resources does a product use and how does it differ from to the usage rates other product lines. Therefore, the executives should definitely not abandon the overhead assignment to the products, but instead use a different accounting method. Practical Capacity and Capacity Cost Rates
From the information given in the Exhibits and in the text I have calculated the practical capacity and the capacity cost rates for the different resources. Table 1 summarizes the results. The practical capacity rates were calculated by multiplying the number of employees/machines with their respective total effective hours per month. The capacity cost rates were calculated by dividing the total monthly cost by the respective practical capacity to become the cost rate of the particular resource per hour.
Table 1: Practical Capacities and Capacity Cost Rates
Note: For exact calculations please see the attached excel file. Cost and Profitability Based on Time-Driven ABC Approach
Table 2 shows the revised costs and profits of Sippican Corporation when calculating those according to the time-driven ABC approach. Table 2: Cost and Profitability Based on Time-driven ABC Approach
Note: Total machine expenses include the expenses for machine production runs and the expenses for machine setups. For exact calculations please see the attached excel file. The expenses in each category were calculated by multiplying the actual usage of the resource (taken from Exhibit 3 and Exhibit 4) by the respective capacity cost rate. It can be inferred from the table that valves is the most profitable product line with a gross margin of 42.8% and not of 35% as obtained by the traditional cost accounting system. The pumps have a gross margin of 19.7% as opposed to 5% and the flow controllers have a negative gross margin of -3.6% as opposed to a gross margin of 38% as calculated using the simple accounting method. These differences in the cost and the resulting profitability of the product lines arise from the fact that according to the time-driven ABC approach the cost are allocated to the...
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