Camelback Communications, Inc. (CCI), located near Phoenix, Arizona, manufactured radio and television antennas. The firm had four distinct product lines, each serving a different aspect of the antenna market. The first product line consisted of simple "rabbit ear" antennas. There were several models in the line ranging from the simplest FM and TV antennas to more complicated designs that could improve reception by rejecting multipath signals. The second product line contained dipole antennas for FM and TV reception. These were more sophisticated antennas than the "rabbit ear" line and were the type typically seen attached to chimneys. The third product line was rotators for the dipole line. Rotators consisted of an electric motor that rotated the dipole and a controller that resided by the receiving unit (FM radio or TV). There was little variation in the motors, but the controllers varied considerably from simple controllers that were operated by turning a knob on the controller base to more sophisticated versions that had present antenna positions keyed to the channel being received. The final product line consisted of two electronic antennas, one for FM and the other for TV. These were used in weak reception areas and, in addition to acting as antennas, amplified the signal so that it was strong enough for the receiver to be able to reproduce it properly. In the last five years, CCI had doubled the number of products offered, expanded the production facility twice, and just recently introduced the electronic antenna line. While CCI was very profitable, company president Lincoln McDowell was concerned about its ability to cost products accurately. In particular, some product seemed exceptionally profitable, while other potential products which the firm should have been able to make, appeared impossible to manufacture at a profit. The production manager was convinced that his production processes were as good as any in the industry, and he was unable to explain the apparent high cost of producing these potential products. 1 McDowell agreed with his production manager and was convinced that the cost accounting system was at fault. He had just recently hired Glenn Peterzon, a management consultant, to analyze the firm's cost system and to prepare a presentation to the senior management team. Specifically, McDowell had asked Peterzon to prepare a simple example that demonstrated how the cost system distorted the firm's knowledge of its product costs. Peterzon had begun his study by documenting the existing cost system. It was a very simple system that used a single burden rate for all overhead costs. The burden rate for the year was determined by adding together the budgeted variable and fixed overhead costs and dividing this sum by the number of budgeted direct labor hours. The standard cost of a product was then found by multiplying the number of direct labor hours required to manufacture that product by the burden rate and adding this quantity to the direct labor and material cost. Peterzon became convinced that the cost system was partially to blame for some of the problems the firm was experiencing. However, with over a hundred products, it was difficult to understand how the cost system was distorting product costs. To help illustrate the source of these distortions to senior management, Peterzon decided to develop a simple four-product model. He decided it would be helpful if the actual production costs of the four products were known a priori (see Table A). Table A Product Costs A B C D Material cost $15.00 $ 5.00 $10.00 $ 5.00 Direct labor 30.00 5.00 15.00 10.00 Variable overhead 15.00 7.50 5.00 7.50 Variable cost $60.00 $17.50 $30.00 $22.50 Fixed Costa $10,000 $10,000 $12,500 $12,500 aProduct lines A and B used identical equipment that could each produce 1,000 units of A or B. Product lines C and D used identical equipment that could each produce 1,000 units of C or D. He then calculated the direct labor allocation rate that the existing single burden rate cost system would generate assuming that each product sold a thousand units, the maximum that could be produced, and that each direct labor hour cost $5. Under this scenario, the costs incurred would be: 2 Costs Incurred ($ thousands) Variable Variable Total Labor Hours Overhead/ Total Product Per Unit Unit No. Units Labor Hours Overhead A 6 $15.00 1,000 6,000 $15,000 B 1 7.50 1,000 1,000 7,500 C 3 5.00 1,000 3,000 5,000 D 2 7.50 1,000 2,000 7,500 Total 4,000 12,000 $35,000 and the new allocation rate: Variable overhead 35,000 Fixed overhead 45,000 Total cost to be allocated $80,000 Labor hours ($60,000/5) 12,000 Allocation rate/hour $ 6.67 Using this allocation rate per hour, Peterzon calculated the standard cost of the four products. Product A B C D Material $15.00 $ 5.00 $10.00 $ 5.00 Labor 30.00 5.00 15.00 10.00 Allocated cost 40.00 6.67 20.00 13.33 Standard cost $85.00 $16.67 $45.00 $28.34 If the firm set out to make a 40% mark-on,b then it would want to charge the following prices for the four products: Product A B C D Standard cost $85.00 $16.67 $45.00 $28.34 40% mark-on 34.00 6.67 18.00 11.34 Selling price $119.00 $23.34 $63.00 $39.68 bMark-on % = profit/cost 3 If industry selling prices were established using actual production costs and a 40% mark-on, they would be: Product A B C D Standard cost $70.00 $27.50 $42.50 $35.00 Mark-on 28.00 11.00 17.00 14.00 Selling price $98.00 $38.50 $59.50 $49.00 By comparing the "industry" prices to the firm's costs and assuming that the firm had to match industry prices, Peterzon could determine which products would appear profitable. Selling price $98.00 $38.50 $59.50 $49.00 Standard cost 85.00 16.67 45.00 28.34 Profit 13.00 21.83 14.50 20.66 Markup % 15% 131% 32% 73% CCI had recently adopted a policy of discontinuing all products whose mark-ons were under 25%. Under this policy, product A would be dropped and additional product B manufactured. Assuming the firm could sell all of product B that it could manufacture, then the sales would be: Budgeted A B C D Current volume 1,000 1,000 1,000 1,000 Actual volume 0 2,000 a 1,000 1,000 aThe unused production capacity was used to produce an additional 1,000 units of B. The resulting product mix was so different from the starting mix that Peterzon decided to recalculate the allocation rate per hour to determine if it had been affected: Costs Incurred ($ thousands) Variable Variable Total Labor Hours Overhead/ Total Product Per Unit Unit No. Units Labor Hours Overhead B 1 7.50 2,000 2,000 $15,000 C 3 5.00 1,000 3,000 5,000 D 2 7.50 1,000 2,000 7,500 Total 4,000 7,000 $27,500 4 and the new allocation rate: Variable overhead 27,500 Fixed overhead 45,000 $72,500 Labor hours ($35,000/5) 7,000 Allocation rate/hour $ 10.36 Questions 1. What will CCI now have to charge for each product to make a 40% mark-on? If CCI maintains its rule about dropping products with a mark-on below 25%, which additional products, if any, will it drop? 2. If you decide to drop additional product(s), recalculate the allocation rate per hour for the new product mix. Repeat Question 1. 3. What is going on? 4. What would happen if the firm kept its existing cost system but differentiated between variable and fixed cost and decided to maximize contribution? 5. What would happen if the firm modified its cost system so that all variable costs were traced to the product accurately but fixed costs were allocated using the existing system? 6. What would happen if the firm modified its cost system so that it contained two cost pools, one containing the overhead costs associated with Products A and B and the other the overhead costs associated with Products C and D, and then allocated these overhead pools on the basis of direct labor hours