Activity-based costing; product decisions: manufacturer Territory Electronics Company (TEC) manufactures two large-screen television models, the Novelle, which has been produced for 10 years and sells for $910, and the Zodiac, a new model which sells for $1160. Based on the income statement for the year just ended, presented below, a decision has been made to concentrate TEC's marketing resources on the Zodiac model and to begin to phase out the Novelle model.

Territory Electronics Company Income statement

Zodiac Novelle Total

Sales $4640000 $20020000 $24 660000

Cost of goods sold 32320001302400016 256000

Gross margin $1408000 $6996000 $8 404000

Selling and administrative expenses 980 00057000006 680000

Net profit $428 000 $1296000 $1 724000

Units produced and sold 4000 22000

Net profit per unit sold $107.00 $58.91*

The unit costs for the Zodiac and Novelle models are as follows:

Zodiac Novelle

Direct material $655 $363

Direct labour:

Zodiac (3.5 hr $14) 49

Novelle (1.5 hr $14) 21

Manufacturing overhead* 104 208

Cost per unit $808 $592

* Manufacturing overhead was applied on the basis of machine hours at a predetermined rate of $26 per hour.

PART TWO COSTS AND COSTING SYSTEMS

Territory Electronics Company's financial controller is advocating the use of activity-based costing and has gathered the following information about the company's manufacturing overhead costs for the year just ended:

Quantity of activity driver consumed

Activity (activity driver) Activity costs Zodiac Novelle Total

Soldering (number of solder joints) $ 880 000 400 000 1200 000 1600000

Shipments (number of shipments) 836 000 3 800 15 200 19000

Quality control (number of inspections) 1170 000 21 060 56 940 78000

Purchase orders (number of orders) 1110 000 105 450 79 550 185000

Machine power (machine hours) 47 500 15 200 174 800 190000

Machine setups (number of setups) 948 500 4 500 4 985 9485

Total activity costs $4992 000

Required:

1. Briefly explain how an activity-based costing system operates.

2. Using activity-based costing, determine whether TEC should continue to emphasise the Zodiac model and phase out the Novelle model.