Holly Manufacturing Company produces two cello models. One is a standard acoustic cello that sells for $600 and is constructed from medium-grade materials. The other model is a custom-made amplified cello with pearl inlays and a body constructed from special woods.

The custom cello sells for $900. Both cellos require 10 hours of direct labor to produce, but the custom cello is manufactured by more experienced workers who are paid at a higher rate.

Most of Hollys sales come from the standard cello, but sales of the custom model have been growing. Following is the companys sales, production, and cost information for last year:

Cello		Standard	Custom
Sales and production volume in units		900	100
Unit Selling Price		$600.00	$900.00
Unit costs:
Direct materials		$150.00	$375.00
Direct labor		$180.00	$240.00
Manufacturing overhead*		$135.00	$135.00
Total unit costs		$465.00	$750.00
Unit Gross Profit		$135.00	$150.00
Direct Labor Hours		10.00	10.00
Direct Labor Rate Per Hour		$18.00	$24.00
* Manufacturing overhead costs:
Building depreciation	$ 40,000
Maintenance	15,000
Purchasing	20,000
Inspection	12,000
Indirect materials	15,000
Supervision	30,000
Supplies	3,000
Total manufacturing overhead costs	$135,000

Selling and Administrative expenses:

Commission to sales person 3 % of Sales Revenue

Advertising, CEO salary, etc. $ 30,000 per year.

* These manufacturing overhead costs are company-wide, fixed in nature: they do not vary with the volume of manufacturing activity.

The company allocates overhead costs using the traditional method. Its activity base is direct labor hours. The predetermined overhead rate, based on 10,000 direct labor hours, is $13.50 ($135,000 10,000 direct labor hours).

Johann Brahms, president of Holly, is concerned that the traditional cost-allocation system the company is using may not be generating accurate information and that the selling price of the custom cello may not be covering its true cost.

President Brahms has hired your consulting team to help him understand cost allocation and provide more accurate information and advice. Here are some questions to guide your work.

A. The cost-allocation system Holly has been using allocates 90% of overhead costs to the standard cello because 90% of direct labor hours were spent on the standard model.

How much overhead was allocated to each of the two models last year?

Discuss why this might not be an accurate way to assign overhead costs to products.

B. How would the use of more than one cost pool improve Holly's cost allocation?

Holly's controller developed the following data for use in activity-based costing:

Manufacturing			Standard	Custom
Overhead Cost	Amount	Cost Driver	Cello	Cello
Building depreciation	$40,000	Square footage	3,000	1,000
Maintenance	$15,000	Direct labor hours	9,000	1,000
Purchasing	$20,000	# of purchase orders	1,500	500
Inspection	$12,000	# of inspections	400	600
Indirect materials	$15,000	# of units manufactured	900	100
Supervision	$30,000	# of inspections	400	600
Supplies	$3,000	# of units manufactured	900	100
Total	$135,000

D. Use activity-based costing to allocate the costs of overhead per unit and in total to each model of cello. Show all supporting calculations. It is appropriate to use an excel document to do your computations in Excel

E. Calculate the cost of a custom cello using activity-based costing.

F. Why is the cost different from the cost calculated using the traditional allocation method?

G. At the current selling price, is the company covering its true cost of production? Briefly explain

H. What price could Holly Manufacturing set that would give about the same profit margin (% ) as the standard cello? Show all calculations.

I. What should Holly Manufacturing do if the quantity of custom cellos sold at the new price falls to 50 per year?

J. What should Holly Manufacturing do about the situation if market conditions are such that the price of the custom cello cannot exceed $900?

At a selling price of $600 for the standard cello and $1,000 for the custom cello, and assuming the same product mix, what is the breakeven unit volume for each cello (remember it is difficult to sell a fraction of a cello, so round-up.You need to consider the product mix when selling 2 products).

Please show President Brahms a contribution Income Statement reflecting the sales at breakeven.

Write a brief report to President Brahms explaining your conclusions and the benefits of your suggestions. What are the lessons learned from this case that can help him understand cost allocation.