Primary Case - The Bottom Line Luke Trahan Kevin McGowan...

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Unformatted text preview: The Bottom Line / ' Luke Trahan Kevin McGowan Hill Taylor Danie} Webb Michael Newman x0 , .35 .W W Destin Brass Products Co. History Steve Abbott, John Scott, and Roland Guidry originally founded Destin Brass Products ‘ Co. in 1984. The three founders hired Peggy Alford, an accountant with manufacturing success, and soon began to fill a need in the water purification industry for brass valves. The company grew quickly because the demand for water purification increased, and Destin Brass became the sole supplier of valves. They then. proceeded to expand into manufacturing pumps, an even larger market than valves, and flow controllers. Currently, valves represent 24% of the company’s revenue, pumps account for 55% of revenue, and lastly, flow controllers account for 21% of W revenue. Product»Costing Problems Destin Brass is facing price competition from their competitors on pumps, their major product line. Reports from recent months have shown that competitors’ prices for pumps are steadily declining. Even though the company has achieved much success through efforts to maintain a 35% gross margin on each product, the company felt it had to match competitors” lower prices to avoid losing market share. Destin managers cannot seem to figure out how competitors can keep reducing prices on pumps while maintaining a profit. The pump market is large with many competitors, and the priceuwar strategy does not seem like it will benefit anyone. Furthennore, Destin has almost no competition in the flow controller market. Even after a 12.5% hike in price last month, Steve Abbott, the sales and marketing manager, could not detect any effect on the demand for the product. These events iead our team to believe that Destin could be incorrectly costing its products. W During a recent meeting aimed at resolving the pricing predicament with pumps, key decision—makers at Destin explored the possibility of adopting a new product—costing system. They identified the main problem as the overhead—allocation method, or deciding the amount overhead. allocated to each product. Destin currently uses a traditional product—costing system, ' which overhead is allocated to each product based on a single cost driver: production—labor I (direct-labor) cost. The current overhead allocation rate is 439% of directdabor cost. $.11 Solution Methodology This type of costing method, known as “peanut~butter” costing, can lead to over costing of high~volume (highly competitive) products, especially when the product consumes a relatively low level of resources. For example, Destin’s pumps require much less engineering effort than flow controllers, but under its traditional costing system, more engineering—related overhead is allocated to pumps (see Appendix A). In order to solve the pump over costing problem due to a “peanut-butter” overhead allocation method, The Bottom Line has analyzed Destin’s product— costing system under an aWach. The team calculated ABC by first determining the costs of significant activities, and then assigning the costs of those activities to the products. A five step process was used in order to calculate ABC: 1. Identify the process that is the cost object I W 2. Label the direct cost categories for the process I 3. Determine the indirect cost pools of significant activities associated with the process 4. Select the cost allocation base to use to apply the overhead costs of each activity/ cost driver to the process 5. Develop the overhead application rate for each activity/ cost driver in following this process, we identified each of the overhead costs associated with the production and sale of the valves, pumps, and flow controllers. These overhead costs consisted 95/ of receiving material, handling material, engineering, packing and shipping, maintenance, set—lap labor, and machine depreciation. Next, the significant activities associated with each of the overhead costs were identified. In doing so, the team determined the percentage of every activity needed for each of the three products. Lastly, the overhead application rate was developed for " each activity/cost driver. This was calculated at the per unit level in order to obtain the total overhead cost per unit for each of the products. Using the overhead cost per unit, the direct material cost per unit, and the direct labor cost per unit, we were able to calculate the total cost per unit for valves, pumps, and flow controllers. As depicted in the numbers attached (see Appendix A), it is easy to observe the amount of differences in allocation of costs between the standard method that was being used and the new approach to the activity based costing system that should be implemented. The main reason why this activity based costing system is superior is due to the fact that is able to more accurately capture the correct costs associated with each product line. With the implementation of the activity based costing system, it creates a change in the cost allocation base significantly for the pumps, and flow controllers, but valves remain relatively the same. The Pumps cost per unit is decreased by a $14.3 luallowing for the company to more accurately price the product and depict the gross profit $311 On the other hand, the W flow controllers cost per unit rises by a total of $jljifil§dxghich conveys that the company is not 0? charging enough money per unit. Also, the new citihg system raises the cost per unit of vaives by a total of 53% keeping it relatively the same. b a“ Ail these differences in cost per units helps to show why activity based costing is a superior system to allocate overhead costs. Due to a more detailed approach of allocating costs by using a larger number of cost pools, activity based costing uniquely identifies the costs associated with each unit compared. to that of the traditional system that was being used by the company. With this new implementation of ABC, the company can hopefully better price their products and recapture their goals for net profit margin for each product. Recommendations It is recommended that Destin Brass use an activity based costing system despite net income bein e nal b tween using an activity based system and a standard costing system. Destin Brass is su stantialiy under estimating unit costs for flow controllers making them appear very profitable, and they are over estimating unit costs for pumps making them appear less profitable. Also, the reason that net income between the two costing systems are equai is because the total costs are not changing, ythe amount of overhead being allocated to each product is changing (see Appendix B). In order to increase net income after choosing to use the activity based costing system, Destin Brass should lower the price of pumps to meet their competitors” prices so that they can sell more of this already profitable product. It is also recommended that Destin Brass increase the price of flow controllers to cover their estimated gross profit margin per product line of 35%. As stated in the case, flow controller prices had already been increased 12 1/2 % with no apparent effect on demand. Destin Brass seems to have a monopoly on the market for flow controilers. Therefore, it is safe to assume that another increase of 12 1K2 % will still have little to no effect on demand and can only increase net income for Destin Brass. This further increase of 12 V2 % will increase the price of flow controllers to $109.20. Assuming demand remains the same at 4,000 units and an ABC cost of$100.81, this increases net income by $33,575.00 (see Appendix C). Choosing an activity based costing system will allow Destin Brass to more adequateiy estimate costs, and therefore allow them to detennine which products are the most profitable in order to make smarter business decisions. Also, by precisely aliocating these over head costs, it will ailow for a better depiction of gross profit margin per product line. Appendix A: Activity Based Costing System Total costs for each activity Receiving: $ 20,000.00 Materials Handling: $ 200,000.00 Engineering: $ 100,000.00 Packing and Shipping: $ 60,000.00 Maintenance: $ 30,000.00 Set~up Labor: $ 2,688.00 Machine Depreciation: $ 270,000.00 Total: $ 682,688.00 Valves Pumgs Ficw Controilers Receiving: 3.00% 19.00% 78.00% $ 600.00 $ 3,800.00 $ 15,600.00 Materials Handling: 3.00% 19.00% 78.00% $ 6,000.00 $ 38,000.00 $ 156,000.00 Engineering: 20.00% 30.00% 50.00% $ 20,000.00 $ 30,000.00 $ 50,000.00 Packing and Shipping: 3.00% 23.00% 73.00% $ 2,000.00 $ 14,000.00 $ 44,000.00 Maintenance: 35.00% 58.00% 7.00% S 10,500.00 $ 17,400.00 $ 2,100.00 Set~up Labor: 4.76% 23.81% 71.43% $ 128.00 $ 640.00 $ 1,920.00 Machine Depreciation: 34.72% 57.87% 7.41% $ 93,750.00 $ 156,250.00 $ 20,000.00 Total Overhead Cost ger Product: $ 132,978.00 $ 260,090.00 $ 289,620.00 Overhead Cost Per Unit: $ 17.73 $ 20.81 $ 72.41 DM Cost per Unit: 8 16.00 $ 20.00 $ 22.00 0:. Cost per Unit: a 4.00 $ 8.00 $ 0.40 / Total Cost gar Unit: $ 37.73 $ 48.81 $ 100.81 M MWW Standard Unit Cost: ‘ 37' 50 e 03 12 $ 50. 50 Revised Unit Cost: 9 00 $ " 47. 90 0%} Change Per Product: Bifference Between ABC and Standard: 0.17 $ (14. 31) $ 44 31 Difference Between ABC and Revised: 8 (11.27) $ (10.14) 0 52.85 Total Change in Income per Product: 33 1,278.00 8 (178,910.00) $ 177,220.00 Appendix B: Change in Net Income Valves Pumps Fiow Controllers Actual Price $ 57.78 $ 81.26 $ 97.07 Standard Unit Cost $ 37.56 $ 63.12 $ 56.50 Activity Based Unit Cost $ 37.73 $ 48.81 $ 100.81 Units Shipped 7500 12500 4000 income (Std Costing) $ 151,650.00 $ 226,750.00 $ 162,280.00 Net income {Std Costing) = $ 540,680.00 income (ABC casting) $ 150,375.00 $ 405,625.00 $ 14,960.00 Net Income (ABC Costing) : $ 541,040.00 ***Difference of $360.00 is due to rounding*** Appendix 0: Increase in Flow Controiiers Price Origina§ Price: $ 97.07 New Price: $ 109.20 Units Said: 4000.00 Totai Revenge: $ 436,800.00 Cost per Unit: $ 100.81 Total Costs: S 403,240.00 Net Profit: $ 33,560.00 ...
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