Question 2

Gigabyte Ltd manufactures three products for the calculator industry:

Product G: annual sales, 8,000 units

Product T: annual sales, 15,000 units

Product W: annual sales, 4,000 units

The company uses a conventional, volume-based product costing system with

manufacturing overhead applied on the basis of direct labour dollars. The product costs

have been calculated as follows:

Product G Product T Product W

Raw material $105.00 $157.50 $52.50

Direct labour 48.00 (2.4 hr x $20) 36.00 (1.8 hr x $20) 2 4.00 (1.2 hr x $20)

Manufacturing

overhead* 420.00 ($48 x 875%) 315.00 ($36 x 875%) 210.00 ($24 x 875%)

Total product cost: $573.00 $508.50 $286.50

* Calculation of predetermined overhead rate:

Manufacturing overhead budget:

Machinery $3,675,000

Machine setup 15,750

Inspection 1,575,000

Material handling 2,625,000

Engineering 1,034,250

Total $8,925,000

Direct labour budget (based on budgeted annual sales)

Product G: (8,000 x $48.00) $384,000

Product T: (15,000 x $36.00) $540,000

Product W: (4,000 x $24.00) $ 96,000

Total $1,020,000

Budgeted overhead

Predetermined overhead rate = ---------------------------- = 875%

Budgeted direct labour

Gigabytes pricing method has been to set a budgeted price equal to 150 percent of full

product cost. However, only product T has been selling at their budget price. The budgeted

and current prices for all the three products are the following:

Product G Product T Product W

Product cost $573.00 $508.50 $286.50

Budgeted price 859.50 762.75 429.75

Actual current selling price 639.00 762.75 600.00

Gigabyte has been forced to lower the price of product G in order to get orders. In contrast,

Gigabyte has raised the price of Product W several times, but there has been no apparent

loss of sales. Gigabyte has been under increasing pressure to reduce the price even further

on product G. In contrast, Gigabytes competitors do no seem to be interested in the market

for product W. Gigabyte apparently has this market to itself.

Required:

a. Is product G the companys least profitable product? Explain.

b. Is product W a profitable product for Gigabyte Ltd? Explain.

c. Comment on the reactions of Gigabytes competitors to the firms pricing strategy.

What dangers does Gigabyte face?

d. Gigabytes financial controller, Nan OSecond, recently attended a conference at

which activity based costing system were discussed. She become convinced that

such a system would help Gigabytes management to understand its product cost

better. She obtained top management approval to design an activity-based costing

system, and an ABC project team was formed. In stage one of the ABC project, each

of the overhead items listed in the overhead budget was placed into its own activity

cost pool. Then an activity driver was identified for each activity cost pool. Finally,

the ABC project team compiled data showing the percentage of each activity driver

was consumed by each of Gigabytes product lines. These data are summarized as

follows:

Activity cost pool Activity Driver Product G Product T Product W

Machinery Machine hours 24% 50% 26%

Machine setup Number of setups 22% 30% 48%

Inspection Number of inspections 16% 44% 40%

Material handling Raw material costs 25% 69% 6%

Engineering Number of change orders 35% 10% 55%

Show how the financial controller determined the percentages given above for raw material

costs. (Round to the nearest whole per cent)

e. Develop product costs for the three products on the basis of a simple activity-based

costing system. (Round to the nearest cent)

f. Calculate a budgeted price for each product, using Gigabytes pricing formula.

Compare the new budgeted prices with the current actual selling prices and

previously reported product costs.

g. Refer to the new budgeted prices for Gigabytes three products, based on the new

activity-based costing system. Write a memo to the company managing director

commenting on the situation Gigabyte has been facing regarding market for its

products and the actions of its competitors. Discuss the strategic options available to

management. What do you recommend, and why?

h. Refer to the product costs developed in required (e). Prepare a table showing how

Gigabytes conventional volume-based product costing system distorts the product

costs of product G, product T and product W.