What changes, if any, should management make to zauner's pricing strategy?

ZAUNER ORNAMENTS As she put the finishing touches on the annual financial statements for Zauner Ornaments, Chia-yi Yu contemplated her schedule for the next few weeks. As the new controller for Zauner Ornaments in Taiwan, Yu thought the slow-sales period in January would be the perfect time for her to focus on Zauner's management-accounting procedures. Yu had recently returned to Taiwan from graduate business school in Europe, and she was anxious to apply the knowledge she had gained at school to her new job. As a first step, Yu decided to research Zauner's current costing methods. Background Zauner Ornaments was a wholly owned subsidiary of Zauner Crystal, Inc., a large manufacturer of crystal and glass products headquartered in Vienna, Austria. Although originally established as an industrial-glass producer, Zauner Crystal reinvented itself after the Second World War as a producer of fine crystal, glass tableware, and other similar products. The company enjoyed an international reputation as a producer of high-quality glass and crystal at affordable prices owing to the skills of its master artisans, as well as the application of innovative technology in the manufacturing process. Zauner crystal was used in fine restaurants, hotels, and residences throughout the world. Zauner Ornaments Several years previously, management at Zauner Crystal recognized that growth in the fine-crystal and glass-tableware markets was beginning to slow, forcing the company to search for other growth opportunities. After extensive research, management concluded that expanding into glass Christmas-tree ornaments would allow the company not only to continue to grow, but also to take advantage of Zauner Crystal's unique capabilities. The company leased a small manufacturing facility in Taiwan, and began producing the following three products there:Ornaments Sales Price Der Box per Box* Small glass ball ornaments 12 $9.00 Large glass ball ornaments $1 1.00 Specialty glass ball ornaments $17.00 "Note: All monetary amounts are expressed in U.S. dollars Cost Accounting at Zauner Ornaments In the third week of January, Yu called the sales department to inquire about price-setting procedures for the different product lines. She quickly discovered that the sales department investigated the prices of similar products available in the marketplace and set Zauner's prices accordingly. Yu knew that the company was profitable overall, but wondered if the prices set by the sales department were sufficient to ensure that the individual product lines were profitable. She decided to have one of her senior analysts, Yung Chen, prepare an analysis of unit-product costs for each of Zauner's three products. She thought this might be helpful in determining whether any adjustments in the product prices were warranted. To assist Chen in his task, Yu provided him with a schedule of the factory's annual overhead costs, as follows: Overhead Item Annual Cost Production scheduling 85.000 Machine setupe 160.000 Equipment depreciation 220,000 Plant depreciation 150,000 Quality inspection 70.000 Packing 185,000 Plant administration 300 000 Total overhead 51.170.000 Later that day, Chen returned to Yu's office with a schedule showing his calculation of product costs for each of Zauner's three products (Exhibit 1). Chen calculated the cost per box for each product, using a traditional volume-based costing system. Budgeted overhead was allocated to each product line, based on the planned production of omaments. Chen and Yu were dismayed by the results of Chen's analysis, according to his calculations, Zauner was selling small glass ornaments for $9.00 a box, but it was costing the company $21.12 a box to produce those ornaments! Yu took these results to the director of Operations, David Metz. "I'm really worried about our pricing and the efficiency of our manufacturing processes," Yu told Metz. "According to this product-cost analysis, we are losing money on both the small and large glass ornamentswe produce, while making money on the specially omamends Surely that can't he the case, can it? Are our costs really that much higher than other lums in the industry?" Metz looked at Chen's schedule and shook his head. "I think I see the problem here," he told Yu. "You've allocated overhead to each product, using production units. Why don't you try this analysis again, this time allocating overhead to each product based upon direct materials and direct labor? I think that method better approximates the actual use of the overhead resource by each product line, and it should fix your problem." Yu returned to her office and instructed Chen to redo his analysis using direct materials plus direct labor as the allocation base for overhead expenses. Chen soon returned with the product-cost schedule shown in Exhibit 2. "Look!" he told Yu. "I think Metz was correct Allocating overhead based on direct materials and direct labor gives us product costs that are below our current sales price for each product line. I think we're fine now." Yu felt better after seeing Chen's second analysis, but she was not fully convinced that the revised schedule captured Zauner's product costs in the most accurate manner. While Chen was working on his analysis, Yu met with the manufacturing department to gain a better understanding of Zauner's operations. The results of these meetings are summarized in Exhibit 3. She learned that, while all three ornaments were made on the same production lines, specialty ornaments underwent an additional painting process. In the specialty-painting department, 24 fully utilized workers hand-painted intricate designs on the inside of each specialty ornament. Yu also discussed with Manufacturing the types of overhead at Zauner and the specific activities that could be generating the company's overhead costs. She discovered that both production- scheduling and machine-setup costs appeared to be driven primarily by the number of batches required for the annual production volume. Because the number of batches varied by product type, Yu concluded that total yearly batches might be an appropriate means of allocating production-scheduling and machine-setup costs to the different product lines. In addition, she had a little more difficulty ascertaining the root cause of equipment depreciation. It was unclear whether equipment depreciation occurred because of the number of machine operations performed or because of the machine run time. Based on feedback from the manufacturing department, she decided that the number of machine operations was the better indicator of equipment depreciation. She also thought that plant depreciation could reasonably be based on the factory square footage used to manufacture, paint, and store each box. Her discussions also led her to conclude that the number of inspections performed drove inspection costs, while the number of boxes used drove packaging costs. Plant administration (which included supervision, labor relations, and clerical costs) appeared to be the most problematic in deciding how best to allocate these costs. Yu would have to make that decision soon, and in the meantime, had gathered the data in Exhibits 4 and 5, which she thought might be useful in her deliberations. After seeing Zauner's manufacturing process, Yu recalled reading about activity-based costing (ABC) in graduate school. She remembered that companies used ABC systems to assignindirect manufacturing costs to products based on the activities performed on those products. Yu thought she might be able to use ABC to reflect Zauner's product costs more accurately, thereby improving product-pricing decisions. Assignment Questions 1. Determine the best base for allocating plant-administration costs. 2. Calculate the ABC costs for each product on a per-box basis. 3. What do these results tell you about activity-based costing versus costing based on standard volume or direct materials plus direct labor? 4. What changes, if any, should management make to Zauner's pricing strategy?Exhibit 1 ZAUNER ORNAMENTS Calculation of Product Costs: Volume-Based Costing System Number of Omaments Number DM & DL Total Allocated Product Total Cost Omaments per Box of Boxes per Box DM & DL Overhead Total Cost per Box Small colored glass 420,000 12 35,000 4.00 S 140,000 599,268 $ 739,268 21.12 Large colored glass 300,000 6 50,000 5.00 250,000 428,049 678,049 13.56 Specialty omaments 100,000 100,000 7.00 700,000 142.683 842 683 8.43 820,000 185,000 $ 1,090,000 $ 1,170,000 $ 2,260,000-6- UVA-C-2181 Exhibit 2 ZAUNER ORNAMENTS Calculation of Product Costs: DM- and DL-Based Costing System Number of Omaments Number DM & DL Total Allocated Total Cost Product Omaments per Box of Boxes per Box DM & DL Overhead Total Cost per Box Small colored glass 420,000 12 35,000 4.00 S 140,000 150,275 S 290,275 8.29 Large colored glass 300,000 6 50,000 5.00 250,000 268,349 518,349 10.37 Specialty omaments 100,000 100,000 7.00 700,000 751,376 1,451,376 14.51 820,000 185,000 $ 1,090,000 $ 1,170,000 $ 2,260,000Exhibit 3 ZAUNER ORNAMENTS Activity Data by Product Machine Number of Number of Operations Omaments Inspections Product Sq. Footage Omaments Batches per Omament per Box per Box Per Box Small colored glass 420,000 800 12 Large colored glass 300,000 750 6 0.5 Specialty omaments 100,000 500 0.2-8- UVA-C-21 Exhibit 4 ZAUNER ORNAMENTS Historical Five-Year Plant-Administration Costs and Other Data Total Plant Ending Inventory Number of Total Direct Administration Costs % of Plant Cost Plant Personnel Customers Labor Costs 2003 Capacity Used $300,000 $90,000 122 1200 $520,000 70% 2002 295,000 83,000 122 1250 515,000 2001 285,000 75% 58,000 119 1100 555,000 2000 85% 280,000 50,000 112 800 540.000 90% 1999 290,000 76,000 116 600 500,000 95%-9. Exhibit 5 ZAUNER ORNAMENTS Plant Data by Product Line Small Colored Large Colored Glass Glass Specialty Omaments Omaments Ornaments Total Ending inventory costs $26,100 $51,300 $12,600 $90,000 Plant personnel: Non-specialty N/A N/A N/A 98 Specialty (painting) 24 24 Number of customers 600 420 180 1,200 Total direct labor costs $83,200 $93,600 $343,200 $520,000 % Plant capacity used N/A N/A N/A 70%