It is January 15, 2020, and you, CPA, work for ABC Management Consultants. You have recently met with your new client, OPLL Corporation. OPLL manufactures three types of industrial valves: flow-control valves, pressure-control valves, and custom valves.

During the past three years, OPLL has seen a decline in demand for the flow-control valve, steady demand for the pressure-control valve, and substantially increased demand for the custom valves. The income statement by product line is included in Appendix II.

Toni Anderson, vice-president of operations, is concerned about the recent trends he is witnessing in the company. "We have top-of-the-line equipment and great employees. Most of our competitors generate a profit margin of 10% before taxes ? we do not. The cost of the flow-control valve is constantly increasing while the unit cost of the custom valve seems to be getting cheaper every year. It makes no sense."

Toni is seeking your advice on changes that should be made to improve profitability. He wants to know whether fixed costs are being allocated appropriately, and if not, he would like your suggestions for an improved allocation methodology, including how these changes would impact the financial statements under current production levels.

Appendix III

Highlights from discussions

Jack Downie (controller):

Although I have no formal training in accounting, I have been doing this for a long time and am very proud of the internal accounting system and the changes that I have introduced over the past five years. We've carefully analyzed the variable and fixed costs using some pretty powerful software. I'm confident that we have an accurate handle on how costs behave as volume rises and falls in the various product lines.

Steve Wong (marketing):

Marketing expenses are included in the fixed selling and administrative costs. The amount of time, energy, and expenses devoted to each of the product lines seems to depend on the volume sold, and I think the current allocation is appropriate.

The big problem I hear about from the sales centres is around our prices. We currently base all of our prices on an approximate 50% markup over variable costs. I am not an expert, but I believe that our selling prices should be more in line with our competitors, and our price should be based on the total costs of the resources really consumed by a product. Instead of our current approach, I would like to see us using the market benchmark, or a total cost + 10% margin pricing strategy. But I certainly would like a third party to analyze these three pricing strategies in order to figure out which one would provide the highest profitability.

Flow-control model:

We charge $2.50 above our competitors' prices on the flow-control model, and this is really cutting into our sales volume. During the past three years, sales have dropped 24,000 units. If we could reduce price to a level at or below the current average market price of $44.50, I expect sales would jump back to 72,000 units per year, which, for us, has always been a level of production that we consider normal.

Pressure-control model:

With respect to the pressure-control model, I feel that the current sales price is aligned with the current market price and, thus, volume should remain at current levels for the foreseeable future if we don't make any changes to the product or its price. It has been stable for the past three years.

Appendix III (continued)

Highlights from discussions

Custom model:

Sales of the custom valves have grown by 4,000 units over the past three years. It is difficult to find out what our competitors are charging, but there is some evidence to suggest that our prices are very attractive to customers. I think we should reinforce the company's strategy of marketing base models and offering the custom model as a service to regular customers at a premium price. If we limit the selling price of the custom model at or below $350, we would be able to sell around 1,000 custom units per year, which is the level we operated at several years ago.

Karl Bechtold (engineering department):

Our new computer-assisted design system has really changed the way we do things around here. When an order comes in, it is tagged as flow-control, pressure-control, or custom. I would guess that 75% of our time is spent on the custom orders, as they usually require significant adaptations. With the reduced demand for the flow-control model, it currently takes up only about 5% of our time. The pressure-control model takes up the remainder of our efforts. If we were to return to more normal levels of production, I guess that we would spend about half of our time on the custom orders and split the remaining hours between the other two lines.

Harvey Palda (quality control):

Nothing leaves this plant that isn't strictly to our customer's specifications. We check the output of the work centres when they begin each job and monitor output randomly. Because the two basic models (flow-control and pressure-control valves) are produced in large batches, I estimate that each model currently takes about 20% of our time. If the volume of flow-control sales returned to its normal level, I am sure that the amount of quality control would increase to about 30%. The pressure-control model would remain at 20% and the remaining time goes to the more difficult custom work.

Frank Sprocket (supervisor machining and assembly):

This new computer-aided manufacturing equipment has really improved our manufacturing procedures, but the machinery is very expensive. The annual depreciation charge is $690,000. We also incur $200,000 in other fixed manufacturing charges, which relate mostly to the volume of goods produced and sold. It seems logical to allocate the other manufacturing charge based on sales volume; however, I have never understood why the accounting system charges so little depreciation to the custom line, because we invested a lot in the machinery to accommodate these special orders for customers.

Appendix I OPLL product information Flow- Pressure- control control Custom Sales price $47.00 $68.00 $1 12.00 Direct material 10.00 14.00 22.00 Direct labour 15.00 22.50 37.50 Variable overhead? 6.00 9.00 15.00 Total variable cost 31.00 45.50 74.50 Contribution margin $16.00 $22.50 $ 37.50 Units sold 50,000 25,000 5,000 Direct labour hours per unit 1.0 1.5 2.5 Machine hours per unit 0.1 0.2 2.0 Notes: 1. The standard labour rate is $15.00 per hour. 2. Variable overhead includes small tools, lubricants, and indirect labour charges. It is applied at a rate of 40% of direct labour.Appendix II OPLL income statement For the year ended December 31, 2019 Flow- Pressure- control control Custom Total Volume (units) 50,000 25,000 5,000 80,000 Sales price $47 $68 $112 Revenue $2,350,000 $1,700,000 $560,000 $4,610,000 Variable costs: Direct material 500,000 350,000 110,000 960,000 Direct labour 750,000 562,500 187,500 1,500,000 Variable overhead 300,000 225,000 75,000 600,000 Total variable costs 1,550,000 1,137,500 372,500 3,060,000 Contribution margin 800,000 562,500 187,500 1,550,000 Fixed costs: Engineering 40,000 30,000 10,000 80,000 Quality control? 65,000 48,750 16,250 130,000 Depreciation3 407,500 305,625 101,875 815,000 Other manufacturing* 125,000 62,500 12,500 200,000 Selling and administrative+ 78,125 39,063 7,812 125,000 Total fixed costs 715,625 485,938 148,437 1,350,000 Net income $84,375 $76,562 $39,063 $200,000 Net income/revenue 3.6% 4.5% 7.0% 4.3% Notes: 1. It has been reliably determined that variable overhead is a function of direct labour dollars. 2. Engineering and quality control are allocated to products based on their relative proportion of total direct labour dollars. 3. Depreciation is allocated to products based on their relative proportion of total direct labour dollars. The depreciation charge includes $125,000 of R&D costs associated with the knife- gate valve. Because this product is not likely to be launched in the near future, it was decided to expense these costs. 4. Other fixed manufacturing overhead and fixed selling and administrative expenses are allocated to products based on the number of units sold