BOOK: Managerial Accounting: Creating Value in a Dynamic Business Environment Hilton, 10e

Case 5-69Traditional versus Activity-Based Costing Systems

PROBLEM:

Madison Electric Pump Corporation manufactures electric pumps for commercial use. The company produces three models, designated as regular, advanced, and deluxe. The company uses a job-order cost accounting system with manufacturing overhead applied on the basis of direct-labor hours. The system has been in place with little change for 25 years. Product costs and annual sales data are as follows:

Regular Model

Advanced Model

Deluxe Model

Annual sales (units).....

20,000

1,000

10,000

Product costs:

Direct material.....

$20

$50

$84

Direct labor.....

20 (1 hr. at $20)

40 (2 hr. at $20)

40 (2 hr. at $20)

Manufacturing overhead*.

170 (1 hr. at $170)

340 (2 hr. at $170)

340 (2 hr. at $170)

Total product cost.....

$210

$430

$464

Manufacturing-overhead budget:
Depreciation, machinery.....	$2,960,000
Maintenance, machinery.....	240,000
Depreciation, taxes, and insurance for factory.....	600,000
Engineering.....	700,000
Purchasing, receiving and shipping.....	500,000
Inspection and repair of defects.....	750,000
Material handling.....	800,000
Miscellaneous manufacturing overhead costs.....	590,000
Total.....	$7,140,000

Direct-labor budget:
Regular model:	20,000 hours
Advanced model:	2,000 hours
Deluxe model:	20,000 hours
Total	42,000 hours

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 regular-model pump has come under increasing price pressure from offshore competitors. The result was that the price on the regular model has been lowered to $220.

Page 222

The company president recently asked the controller, "Why can't we compete with these other companies? They're selling pumps just like our regular model for $212. That's only two bucks 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.

Product Lines

Activity Cost Pool

Cost Driver

Regular Model

Advanced Model

Deluxe Model

I: Depreciation, machinery

Machine time

39%

13%

48%

Maintenance, machinery

II: Engineering

Engineering hours

47%

6%

47%

Inspection and repair of defects

III: Purchasing, receiving, and shipping

Number of material orders

47%

8%

45%

Material handling

IV: Depreciation, taxes, and insurance for factory

Factory space usage

42%

15%

43%

Miscellaneous manufacturing overhead

Required:

1. 1.) Compute the target prices for the three pump models, based on the traditional, volume-based product-costing system.
2. 2.) Compute new product costs for the three products, based on the new data collected by the controller. Round to the nearest cent.
3. 3.) Calculate a new target price for the three products, based on the activity-based costing system. Compare the new target price with the current actual selling price for the regular model pump.