Tony Lopez, president of Touch Tech Inc., was reviewing the product profitability reports with the controller, Rhamel Rucker. The following conversation took place:
Tony: I’ve been reviewing the product profitability reports. Our high-volume calculator, the T-100, appears to be unprofitable, while some of our lower-volume specialty calculators in the T-900 series appear to be very profitable. These results do not make sense to me. How are the product profits determined?
Rhamel: First, we identify the revenues associated with each product line. This information comes directly from our sales order system and is very accurate. Next, we identify the direct materials and direct labor associated with making each of the calculators. Again, this information is very accurate. The final cost that must be considered is the factory overhead. Factory overhead is allocated to the products, based on the direct labor hours used to assemble the calculator.
Tony: What about distribution, promotion, and other post-manufacturing costs that can be associated with the product?
Rhamel: According to generally accepted accounting principles, we expense them in the period that they are incurred and do not treat them as product costs.
Tony: Another thing, you say that you allocate factory overhead according to direct labor hours. Yet I know that the T-900 series specialty products have very low volumes but require extensive engineering, testing, and materials management effort. They are our newer, more complex products. It seems that these sources of factory overhead will end up being allocated to the T-100 line because it is the high volume and therefore high direct labor hour product. Yet the T-100 line is easy to make and requires very little support from our engineering, testing, and materials management personnel.
Rhamel: I’m not too sure. I do know that our product costing approach is similar to that used by many different types of companies. I don’t think we could all be wrong.
Is Tony Lopez’s concern valid, and how might Rhamel Rucker redesign the cost allocation system to address Tony’s concern?