Kelowna Inc. produces three products- A-111, B-222 and C-333. While the products have been quite profitable over the past few years and the company operates at full capacity (based on machine hours), there has been increased competitive pressure recently which has caused the company to re-evaluate its products. The company allocates manufacturing overhead on the basis of direct labour costs. The income statement for the most recent fiscal year is presented in Exhibit 1. Based on these financial statements, the company is considering reducing production of the A-111 model and transferring production to the C-333 model. They feel there is a chance to increase market share in that segment. From the profitability statement in Exhibit 1, they feel the C-333 model provides higher margins. The vice president of finance was not convinced this decision was appropriate. He decided to re-evaluate the allocation of overhead costs using activity based costing, before making a final decision on the A-111 model. The review was conducted with the understanding that there was no ability to increase available machine hours, from the current annual level of 28,250 hours, in the immediate future. All selling and administrative expenses are considered to be fixed. Question 3 (continued) The vice-president reviewed the major components of overhead (a total of $1,200,000) and determined that the major activities driving the manufacturing overhead costs were: 1. Set-ups Inventory handling WN Machine operations With the activities identified the vice-president determined the following unit rates for the activities, based on the information given in Exhibit 2: Activity Amount Unit rate Set-ups $180,000 $300.00 per set-up hour Inventory handling 210,000 $100.00 per material movement Machine operations 810,000 $30.00 per machine hourExhibit 1 Kelowna Inc. Product Profitability Statement A-111 B-222 C-333 Total Sales $1,300,000 $1 100,000 $500,000 $2,900,000 Material costs 200,000 160,000 40,000 400,000 Direct labour 150,000 120,000 30,000 300,000 Overhead (@400%) 600,000 480,000 120,000 1,200,000 Cost of goods sold 950,000 760,000 190,000 1,900,000 Gross margin $350,000 $340,000 $310,000 $1,000.000 Gross margin % 26.9% 30.9% 62.0%% 34.5% Volume 40,000 30.000 5.500 Potential Market Demand 45,000 34.000 10.000 Exhibit 2 Kelowna Inc. Production Information A-111 B-222 C-333 Sales volume 40,000 30,000 5,500 Production runs 50 30 25 Set-up time per run 2 5 14 Material movements per run 18 15 30 Machine hours per unit .35 .25 1.0