For the past 10 years, the company's pricing formula has been to set each product's target price at 110 percent of its full product cost. Recently, however, the standard-model motor has come under increasing price pressure from offshore competitors. The result was that the price on the standard model has been lowered to $110.
The company president recently asked the controller, “Why can't we compete with these other
companies? They're selling motors just like our standard model for 106 dollars. That's only a buck more than our production cost. Are we really that inefficient? What gives?”
The controller responded by saying, “I think this is due to an outmoded product-costing system. As you may remember, I raised a red flag about our system when I came on board last year. But the decision was to keep our current system in place. In my judgment, our product-costing system is distorting our product costs. Let me run a few numbers to demonstrate what I mean.”
Getting the president's go-ahead, the controller compiled the basic data needed to implement an activity-based costing system. These data are displayed in the following table. The percentages are the proportion of each cost driver consumed by each product line.
1. Compute the target prices for the three models, based on the traditional, volume-based product costing system.
2. Compute new product costs for the three products, based on the new data collected by the controller. Round to the nearest cent.
3. Compare and contrast costs under traditional costing and ABC. What amounts are over/under costed. Are there any cost distortions?
4. Calculate a new target price for the three products, based on the activity-based costing system.
5. Compare the new target price with the current actual selling price for the standard-model electric motor.
6. Write a memo to the company president explaining what has been happening as a result of the firm's traditional, volume-based product-costing system.
7. What strategic options does Morelli Electric Motor Corporation have? What do you recommend, and why?
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- Year 0 – Purchase 20% for $1 million Year 3 - Purchase 25% for $4 million Year 5 - Purchase 10% for $5 million Year 6 – Company is sold for $120 million.