Distortions Caused by Inappropriate Overhead Allocation Base Chocolate Bars, Inc. (CBI), manufactures creamy deluxe chocolate candy bars. The firm has developed three distinct products: Almond Dream, Krispy Krackle, and Creamy Crunch. CBI is profitable, but management is quite concerned about the profitability of each product and the product costing methods currently employed. In particular, management questions whether the overhead allocation base of direct labor-hours accurately reflects the costs incurred during the production process of each product. In reviewing cost reports with the marketing manager, Steve Hoffman, who is the cost accountant, notices that Creamy Crunch appears exceptionally profitable and that Almond Dream appears to be produced at a loss. This surprises both him and the manager, and after much discussion, they are convinced that the cost accounting system is at fault and that Almond Dream is performing very well at the current market price. Steve decides to hire Jean Sharpe, a management consultant, to study the firm's cost system over the next month and present her findings and recommendations to senior management. Her objective is to identify and demonstrate how the cost accounting system might be distorting the firm's product costs. Jean begins her study by gathering information and documenting the existing cost accounting system. It is rather simplistic, using a single overhead allocation base-direct labor-hoursto calculate and apply overhead rates to all products. The rate is calculated by summing variable and fixed overhead costs and then dividing the result by the number of direct labor-hours. The product cost is determined by multiplying the number of direct labor-hours required to manufacture the product by the overhead rate and adding this amount to the direct labor and direct material costs. CBI engages in two distinct production processes for each product. Process 1 is labor intensive, using a high proportion of direct materials and labor. Process 2 uses special packing equipment that wraps each individual candy bar and then packs it into a box of 24 bars. The boxes are then packaged into cases, each of which has six boxes. Special packing equipment is used on all three products and has a monthly capacity of 3,000 cases, each containing 144 candy bars (= 6 boxes x 24 bars). To illustrate the source of the distortions to senior management, Jean collects the cost data for the three products, Almond Dream, Krispy Krackle, and Creamy Crunch. Almond Dream Krispy Krackle Creamy Crunch Product costs Labor-hours per case Total cases produced Material cost per case Direct labor cost per case Labor-hours per product Total overhead = $69,500 Total labor-hours = 11,000 Direct labor costs per hour = $6 Allocation rate per labor-hour = (a). Costs of products 7 3 1,000 1,000 1,000 8 $ 2 $ 9 42 $ 18 $ 6 7,000 3,000 1,000 Material cost per case 8 2 9 Direct labor cost per case 42 18 6 Allocated overhead per case(to be computed) Product cost (b) (c) (d) (g) CBI recently adopted a general policy to discontinue all products whose gross profit margin percentages [(Gross margin + Selling price) 100] were less than 10 percent. By comparing the selling prices to the firm's costs and then calculating the gross margin percentages, Jean could determine which products, under the current cost system, should be dropped. The current selling prices of Almond Dream, Krispy Krackle, and Creamy Crunch are $85, $55, and $35 per case, respectively. Overhead will remain $69,500 per month under all alternatives. Required: a. Complete the table under the current cost system. Determine which product(s), if any, should be dropped. What characteristic of the product that should be dropped makes it appear relatively unprofitable? (10 pts) b. Assume that CBI drops the product(s) identified in requirement (a) above. Calculate the gross profit margin percentage for the remaining products. Assume that CBI can sell all products that it manufactures and that it will use the excess capacity from dropping a product to produce more of the most profitable product. If CBI maintains its current rule about dropping products, which additional products, if any, should CBI drop under the existing cost system? (10 pts) c. Assume that CBI drops the products identified in requirements (b) and (c) above. Recalculate the gross profit margin percentage for the remaining product(s) and ascertain whether any additional product(s) should be dropped. Which additional products, if any, should CBI drop under the existing cost system? (10 pts) d. Discuss the outcome and any recommendations you might make to management regarding the current cost system and decision policies. (5 pts) Jean Sharpe decides to gather additional data to identify the cause of overhead costs and figure out which products are most profitable. She notices that $30,000 of the overhead originated from the equipment used. She decides to incorporate machine-hours into the overhead allocation base to determine the effect on product profitability. Almond Dream requires 2 machine-hours per case, Krispy Krachle requires 7 hours per case, and Greamy Crunch requires 6 hours per case. Additionally, Jean notices that the $15,000 per month spent to rent 10,000 square feet of factory space accounts for almost 22 percent of the overhead. The assignment of square feet is 1000 to Almond Dream, 4000 to Krispy Krackle, and 5000 to Creamy Crunch. Jean decides to incorporate this into allocation based for the rental costs. Because labor-hours are still an important cost driver for overhead, Jean decides that she should use labor-hours to allocate the remaining $24,500. CBI still plans to produce 1,000 cases each of Almond Dream, Krispy Krackle, and Creamy Crunch. Assume that CBI can sell all products it manufactures and that if it drops any products, it will use excess capacity to produce additional cases of the most profitable product. Overhead will remain $69,500 per month under all alternatives. Required: e. Based on the additional data, determine the product cost and gross profit margin percentages of each product using the three allocation bases (labor-hours, machine-hours, and square feet) to determine the allocation assigned to each product. Which product would management recommend dropping? (20 pts) f. What characteristic of the product that should be dropped makes it appear relatively unprofitable? Discuss why the outcome is different from the current cost system and provide recommendations to management regarding the new cost system. (10 pts)