Activity-Based Costing as an Alternative to Traditional Product Costing "The gross margin on our briefcases is ridiculous!" roared Art Dejans, president of CarryAll Inc. "Why do we go on producing those standard briefcases when we're able to make much more on our specialty items? Maybe it's time to get out of the standard line and focus the whole plant on specialty work." Mr. Dejans is referring to a summary of unit costs and revenues that he had just received from the company's Accounting Department: Standard Specialty Briefcases Briefcases Selling price per unit. Unit product cost $36 ? $40 ? CarryAll produces briefcases from leather, fabric, and synthetic materials in a single plant. The basic product is a standard briefcase that is made from leather lined with fabric. The standard briefcase is a high-quality item and has sold well for many years. Last year, the company decided to expand its product line and produce specialty briefcases for special orders. These briefcases differ from the standard in that they vary in size, they contain the finest synthetic materials, and they are imprinted with the buyer's name. To reduce labour costs on the specialty briefcases, most of the cutting and stitching is done by automated machines. These machines are used to a much lesser degree in the production of standard briefcases. "I agree that the specialty business is looking better and better," replied Sally Henrie, the company's marketing manager. "And there seems to be plenty of specialty work out there, particularly since the competition hasn't been able to touch our price. Did you know that Armor Company, our biggest competitor, charges over $50 a unit for its specialty items? Now that's what I call gouging the customer!" A breakdown of the manufacturing cost for each of Carry All's product lines is given below: Standard Briefcases Specialty Briefcases 10.000 2.500 Units produced each month Direct materials: Leather Fabric Synthetic Total materials Direct labour 1.0 sq. m. 1.0 sq. m. $15.00 5.00 0.5 sq. m. 1.0 sq. m. $7.50 5.00 5.00 17.50 3.00 20.00 6.00 0.5 hr. @ $12 0.25 hr. @ $12 Manufacturing overhead is applied to products on the basis of direct labour-hours. The estimated manufacturing overhead cost each month is $101,250. 1 The following additional information is available about the company and its products: a. Standard briefcases are produced in batches of 200 units, and specialty briefcases are produced in batches of 25 units. A setup for the standard items requires one hour of time, whereas a setup for the specialty items requires two hours of time. b. All briefcases are inspected to ensure that quality standards are met. A total of 300 hours of inspection time is spent on the standard briefcases and 500 hours of inspection time is spent on the specialty briefcases each month. C. A standard briefcase requires 0.5 hour of machine time, and a specialty briefcase requires 2 hours of machine time. d. The company is considering the use of activity-based costing as an alternative to its traditional costing system for computing unit product costs. Since these unit product costs will be used for external financial reporting, all manufacturing overhead costs are to be allocated to products. The activity-based costing system has already been designed and costs allocated to the activity cost pools. The activity cost pools and activity measures are as follows: Activity Cost Pool Estimated Overhead Cost Machine related. Purchasing materials. Frame assembly Production orders and setups Inspection. Material handling $30,000 $12,000 $8,000 $20,250 $16,000 ..$15,000 Expected Activity Standard Specialty Briefcase Briefcase Activity Measures Total 34 48 6 12 100 40 60 100 Number of purchase orders: Leather.. Fabric. Synthetic material Number of material receipts: Leather... Fabric.... Synthetic material Setup hours. Inspection-hours Assembly-hours Machine-hours 52 64 ? ? 800 ? 8 16 160 ? ? 800 ? 60 80 160 ? ? 1,600 ? 2 Required 1. Using the current costing system, determine the unit cost of each standard briefcase and each specialty briefcase. 2. Using activity-based costing, determine the amount of manufacturing overhead cost that would be applied to each standard briefcase and each specialty briefcase. 3. Determine the unit product cost of each product line using the activity-based costing system. 4. Based on the data provided, evaluate the president's concern about the profitability of the two product lines. Would you recommend that the company shift its resources entirely to production of specialty briefcases? Show your calculations and explain. 5. Sally Henrie stated that "the competition hasn't been able to touch our price" on specialty business. Why do you suppose the competition has not been able to touch CarryAll's price? 6. Ideally, what change() should be made in CarryAll's activity-based costing system if it is to be used for making decisions about products. Should the unit product cost for external reporting purposes always be used for pricing decisions? Explain