6-1 EASTSIDE MEDICAL TESTING [LO 5] CA Eastside Medical Testing performs five different tests (T1-T5) to detect drug use. Most clients are referred to the company by potential employers who pay for the tests. Revenue and costs related to the tests, for the most recent fiscal year, are detailed in the table below. Setting up equipment to conduct a test is the responsibility of three highly skilled technicians, one of whom is Emmet Wilson, founder and owner of the com- pany. Tests T2 to T5 are high-volume tests that are con- ducted in batches of 100 tests per batch. Thus, for example, T5 is run approximately three times a day to annually process 92,000 tests in 920 batches. T1 is a test with relatively low demand. However, it is run almost every day (350 runs per year), so that results can be quickly communicated to employers. This fast turn- around represents a significant competitive advantage for the company. Nuclear Systems, Inc., is one of the few companies that requires T1. Indeed, it accounted for almost half of the 3,500 T1 tests conducted in the past year. Recently, Ron Worth, vice president of operations at Nuclear Systems, SE insingp3 questioned the relatively high price being charged for T1. In a letter to Emmet Wilson he noted: We pay $35 for each T1 test, which is about 40% higher than your next most expensive test. Is this charge warranted? Frankly, this isn't just a matter of dollars and cents. We believe that we are being taken advantage of because we are one of the few companies that requires the test, and you are one of the few companies that provide it. If we believed that the high price was justified in terms of significantly higher costs, we would not be writing this letter. Before responding to Worth's letter, Emmet reviewed the revenue and cost data presented in the table below. As indicated, T1 produced a profit of $6.50 per test, which was much higher than the profit per test of any of the other procedures. However, since taking a day-long con- tinuing education course at City College (titled ABC and Managing by the Right Numbers!), Emmet has wondered whether the profitability of tests is being distorted by the company's simple approach to allocating over- head-overhead allocation is based on direct labor cost. Direct labor consists of wages and benefits paid to rel- atively unskilled technicians who prepare samples for testing. This cost, $325,650, is only 9.6 percent of total overhead. With help from his bookkeeper, Emmet began to analyze overhead costs in an attempt to calculate the 31.2014 T1 3,500 52,000 Number of runs 350 520 Worth, vice president of operations at Nuclear Systems, year. Recently, Ron overhead. With help from his bookkeeper, Emmet began to analyze overhead costs in an attempt to calculate the Profitability of Tests for the Fiscal Year Ending December 31, 2014 Number of tests per year T2 T3 T4 T5 Total 72,000 80,000 92,000 720 800 920 299,500 3,310 Price per test $ 35.00 $ 26.00 $ 22.00 $ 21.00 $ 20.00 Less: Material cost 12.00 10.50 7.50 7.35 5.85 Direct labor at $18 per hour 1.50 1.00 1.10 1.10 1.10 Overhead at $10.40 per labor hour 15.60 10.40 11.44 11.44 11.44 Total cost 29.10 21.90 20.04 19.89 18.39 Profit per test $ 5.90 $ 4.10 $ 1.96 $ 1.11 $ 1.62 Total profit $20,650 $ 213,200 $141,120 $ 88,800 $ 148,120 Total overhead $54,600 $540,8000 $823,680 $915,200 $1,052,480 Total labor $ 5,250 $ 52,000 $ 79,200 $ 88,000 $ 101,200 $ 742,150 $3,386,760 $ 325,650 253 ABC cost of the five tests. In the past year, overhead amounted to $3,386,760, as follows: ye yb B Overhead Costs a Setup labor $ 925,760 b Equipment 1,476,000 Rent 390,000 y Billing 235,000 Clerical 160,000 Other 200,000 Total $3,386,760 a F b b Emmet's analysis of these six overhead cost categories was as follows: Setup labor ($925,760). This amount is essentially the salary and benefits paid to Emmet and the two other skilled technicians who set up equipment for testing batches of T1 to T5. Emmet believes that the number of runs (batches of tests) is a valid driver for this cost pool. In the past year, there were 3,310 runs. Equipment ($1,476,000). This amount is depreciation on equipment used to process the tests. All of the major pieces of equipment are used in each test. (In other words, no major piece of equipment is used exclusively for any indi- vidual test.) Emmet believes that the amount of direct labor cost is a valid driver for this cost pool. This follows because equipment hours vary with direct labor hours and direct labor cost. In the past year, total direct labor was $325,650. Rent ($299,500). This amount is the annual rent on the facility occupied by Eastside Medical Testing. Emmet believes that the number of tests (300,000 in the prior d year) is a valid driver for this cost pool since each test benefits equally from the incurrence of rent expense. Billing ($235,000). This amount is the annual salary and benefits of two billing clerks as well as a variety of other charges (e.g., billing software costs). Emmet believes that the number of tests (300,000 in the prior year) is a valid driver for this cost pool since each test requires a separate billing charge. Clerical ($160,000). This amount is the annual salary and benefits of two general clerical employees who process orders for supplies, file records, and so on. Emmet believes that the number of tests (300,000 in the prior year) is a valid driver for this cost pool since each test benefits equally from the incurrence of clerical expense. Other ($200,000). This amount includes the salary and benefits of the bookkeeper, depreciation on office equip- ment, utilities, and so on. Emmet believes that the num- ber of tests (299,500 in the prior year) is a valid driver for this cost pool since each test benefits equally from the incurrence of these expenses. Required a. Based on Emmet's assumptions, calculate the ABC cost per unit and profit per unit of each test. Round to 4 decimal places. b. Should Emmet lower the price of the T1 test, or keep the current price and risk losing the business of Nuclear Systems? c. Assume that Emmet, based on his ABC analysis, decides not to lower the price of the T1 test. What will be the effect on annual company profit if the company loses the business of Nuclear Systems (i.e.,T1 tests decrease by 1,750)? b E u $ W