Product profitability analysis Pharaoh Phawcetts, Inc. manufactures two mod- LO 1, 3, 4, 5, els of faucets: a regular and a deluxe model. The deluxe model, introduced just 10 two years ago, has been very successful. It now accounts for more than half of the firm's profits as evidenced by the following income statement for 2000:

Its manufacturing plant in Phoenix, Arizona, has two production depart¬ ments: a machining department and an assembly department. The cost of goods sold included $720,000 in production support costs. The plant accoun¬ tant traced $192,000 of the production support costs to the machining depart¬ ment and $168,000 to the assembly department. The balance of $360,000 was attributed to the various service departments, and in the existing cost al¬ location system, the $360,000 was allocated to the machining and the assem¬ bly departments in the proportion of their respective machine hours. Next, separate cost drivers were determined for the two production departments based on their respective direct labor hours to assign the support costs to the two products.

The direct labor wage rate is $10.00 per hour. Direct materials cost is $0.80 per unit for the regular model and for the deluxe model is $1.10 per unit. An average customer order for the regular model is for 5000 faucets, but for the deluxe model, each order is for 2000 units. The machines required a setup for each order. Three hours are required per machine setup for the regu¬ lar model; the more complex deluxe model requires five hours per setup.
Pharaoh Phawcett's profitability has been declining for the past two years despite the successful introduction of the deluxe model, which has now cap¬ tured over a 65% share of its segment of the industry. Market share for the regular model has decreased to 12%. In an attempt to understand the reasons for its declining profitability, the company has appointed a special task force.
The task force is considering a new cost accounting system based on ac¬ tivity analysis. This system employs four cost drivers: two departmental direct labor hours, setup hours, and number of orders. Production support costs are traced to four homogeneous cost pools, each identified with a unique driver as presented in the following table.

REQUIRED

(a) Determine the product costs per unit using the existing cost accounting system. Show all the intermediate steps including the cost driver rates and a breakdown of product costs into each of their components.

(b) Determine the product costs and profits per unit using the new activity- based costing system. Show all the intermediate steps including the cost driver rates and components of product costs.

(c) Explain the principal reasons that the old cost accounting system at Pharaoh Phawcetts may be distorting its product costs and profitability. Support your answer with numbers when necessary.

(d) Analyze the profitability of the two products. What insight does the new profitability analysis provide? What should Pharaoh Phawcetts do to im¬ prove its profitability? What options may be available?

(e) Ryan O'Reilley is a marketing manager with considerable experience as a salesperson. Discuss how he is likely to react to your analysis and recom¬ mendations.

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ITEM Sales TOTAL $2,400,000 REGULAR DELUXE $1,200,000 $1,200,000 Cost of goods sold 1,540,000 771,000 769,000 Gross margin $860,000 $429,000 $431,000 Selling/administrative expenses 500,000 250,000 250,000 Net income $360,000 $179,000 $181,000 Number of units 500,000 300,000 200,000