Sonja Shay May 9, 2010 COST AND MANAGERIAL ACCOUNTING AC341.XG1.

10SPR Destin Brass Company ABC Costing Proposal Through our current costing approach we simply use one cost driver, labor cost dollars. For every $1.00 of run labor cost, we allocate $4.39 of overhead to the product that the labor was applied to. This is a very traditional cost approach which fulfills our financial reporting and tax needs. The revised unit costs presented earlier took set-up labor out of overhead and assigned it directly to products. Activity based costing furthers the effort of correctly assigning costs to our products. Using multiple cost pools and finding out their cost drivers we can more accurately price our products. This will help us to determine why our competitors can sell the pumps so cheaply and why our 12 % increase in the price of the flow controllers did not meet with a decrease in demand. Below is a chart of the proposed activity based costing system. It includes the indirect cost pools, the cost-allocation base, the cost objects (our products), and the direct costs: Exhibit 1 Receiving and handling $220,000

Engineering $100,000

Maintenance

Depreciation

$30,000

$270,000

Packaging/ Shipping $60,000

129
Transactions each

100% work orders

10,800 Machine Hours

10,800 Machine Hours

30
Transactions

$1,705.43 per Transaction

20% valves $2.78 per hour 30% pumps 50% flow controllers

$25 per hour

$2,000 per transaction

Indirect Costs Direct Costs

Direct Materials

Direct Labor

Set-up Labor

Exhibit 1 shows the different cost pools, the direct costs, and their cost drivers. The cost pools are receiving and handling, engineering, maintenance, depreciation, and packaging and shipping. These are driven by how many transactions take place, the machine hours used, and the engineering work orders. Exhibit 2 furthers the information shows in Exhibit 1. Exhibit 2 Budgeted Quantity of CostAllocation Base 4 Cause and Effect Relationship Between Allocation Base and Activity Cost Costs increase with increase in transactions Costs increase with increase in transactions of shipping Costs increase with amount of engineering for each product Costs increase with increase in machine hours Costs increase with increase of machine hours

Activity 1

Cost Hierarchy Category 2

Total Budgeted Indirect Costs 3

Budgeted Indirect Cost Rate 5 = 3/4 $1705.43 per transaction

Receiving and Handling Batch- level

129 $220,000 transactions

Packaging and shipping

Batch-level

30 $60,000 transactions

2000 per transaction

Engineering

Productsustaining

Percentage of $100,000 work orders

$100 per percentage

Maintenance unit- level

$30,000

10,800 machine $2.78 per hours hour 10,800 machine hours $25 per hour

Depreciation

unit- level

$270,000

Below, in Exhibit 3 we can see the product costs using activity based costing for the valves, pumps, and flow controllers. This shows both direct and indirect costs, unit level and total costs. Exhibit 3 can be seen in the attached Excel file. As we can see, the revised costs are a step towards the activity based costing costs, but they do not separate the overhead as truly. In exhibit 3 we can see that the overhead is allocated to each product based on how much each product actually uses that resource. It does not make sense to allocate engineering overhead evenly when flow controllers are using up 50% of it. Therefore, by using cost pools and the cost drivers we can see a more accurate cost for our products. This also helps us explain why the other companies are able to sell their pumps for a price well below ours and still make a profit. An examination of the cost differences will help to bring further light to this situation.

Below is a table comparing the different product costs per unit based on the different costing methods. Exhibit 4 Valves $37.56 $49.00 $37.73 Pumps $63.12 $58.95 $48.81 Flow Controllers $56.50 $47.96 $100.81

Standard Unit Costs Revised Unit Costs ABC Costs

As we can see, there is a variance in unit costs depending on the costing method. It is important to remember that the different costing methods simply use a different approach to assigning the indirect costs. Activity based costing provides the best picture to how much each of our products costs us to produce. This is because rather than just using one cost pool, as in our case is direct labor dollars, we use several cost pools to more accurately assign costs to the products that use those resources. As stated above with the example of the engineering overhead. Likewise, the depreciation costs would be greatest per unit to the pumps because they use the most machine hours, and depreciation is closely a result of usage. Therefore it would not make sense to allocate the same amount of depreciation costs to all three products. This logic is followed for all the cost pools. The revised unit costs differ from both because in calculating them we assigned set-up costs as a direct cost since it can be directly traced to each product. This gives us a better picture of costs, but not as accurate as the ABC costs at the bottom of exhibit 4. Based on our current cost structure, we are allocating too much overhead to the pumps and not enough to the flow controllers. This is what is causing our confusion with the two. Our competitors prices are not that low now that we can see how much our pumps actually cost us to produce. Furthermore, we are way under pricing our flow controllers, which would explain why we were able to increase their price 12 % without a change in demand. Even with that price increase we are still charging less for them than it costs us to make them. The strategic implications of this are that with better cost knowledge we can better price our products and focus on the most profitable products that we have. As we can see, with our prices of flow controllers at $97.07 we are actually losing $3.74 per unit. Our most profitable product actually costs us money to sell. This needs to trigger a change in our pricing and our marketing objectives. Our goal is to have a gross margin of 35%; with our current cost and pricing structures we are achieving 35% on our valves, 22% percent on our pumps, and 42% on our flow controllers. With the new cost structure, to achieve a 35% gross margin across the board we should set our prices at $58.05 for valves, $75.09 for pumps, and $155.09 for flow controllers. Exhibit 5 shows this side by side comparison.

Exhibit 5 Actual Sales Price Valves Pumps Flow Controllers $57.78 $81.26 $97.07 Actual Gross Margin 35% 22% 42% Proposed Sales Price $58.05 $75.09 $155.09 Proposed Gross Margin 35% 35% 35% Percent difference in Sales price 0.4% 7.6% 59.7% Increase or Decrease Increase Decrease Increase

As we can see, we could easily make the price change to the valves and most likely not be met with a change in demand. The good news is that we will be able to lower our price on our pumps to remain competitive in that market and still turn a profit. The problem area comes with our flow controllers. It is questionable that our customers are willing to take a 59.7% increase in price in one step. We have a few options in regards to this area, slowly increase the price of the flow controllers, or cut them as our of our product. More information would be needed to make this decision. We should initially attempt to raise prices before we decide to cut them out completely as one of our product. In conjunction with that, we can also use the new costing approach to see where we can potentially save money in an effort to either reduce prices for our customers, or to keep prices the same and increase our profits. But again, this is something that needs to be looked into further before we can make any concrete decisions. My suggestion for now is to lower the prices of our pumps to help maintain our position in the market, while continuing to increase our prices on the flow controllers while at the same time researching ways to reduce the cost of producing the flow controllers. It is very important that we dont shy away from the information we can gain from the activity based costing. This can help us in more departments than just pricing. As an analysis for our future earnings if we are to switch to activity based costing, which is being recommended by the accounting department, we have compiled the projected net income for the following month based on the standard cost system and then again based on the proposed activity based costing system. Under the present costing system we have a gross margin of $20.22 for valves, $18.14 for pumps, and $40.57 for flow controllers, multiplying this by the respective units sold (7500, 12500, 4000), and adding the amounts together we have a sales revenue of $540,680. Following the same procedure as above but using the new costs, which yield a gross margin of $20.05, $32.45, and $-3.74 for valves, pumps, and flow controllers respectively, gives us a sales revenue of $541,040. Therefore the difference in income would be $360 dollars higher under the new activity based costing system. As we can see the difference is small, because we are still incurring the same amount of costs

across the board, they are simply being allocated to the products in a more accurate way. Of course, when we change our prices to align with our 35% planned gross margin, the demand will change and we should see a higher income from a higher demand for our pumps. But as our prices stand now, we do not see much change in income by changing the cost structure we use internally. In conclusion, we can see how the different methods we use to cost our products can have a different effect on our business strategies and the products we focus most on. Prior to calculating our activity based unit costs, we thought that our flow controllers were our most profitable product, when we can see that they in fact are costing us money. Furthermore, this helps explain why our customers can sell their pumps so cheap and still cover their costs of business, and why we were able to raise our prices on the flow controllers without a decrease in demand. Changing over to the activity based costing system will require some work at first, but it will not be any extra work to maintain on a regular basis as compared to our current cost approach. The insights we will gain on our companys standing will far outweigh the extra costs and effort of implementing this new costing approach. We will have a more thorough knowledge of our products, be able to see areas that can be improved upon more readily, and provide the best prices for our customers while still achieving our profit goals. For these reasons I believe that we should most definitely switch over to the activity based costing system and do a follow up to determine the prices that we begin to charge for our products based on the current market and this new information.