Statement of the Problem
Destin Bras Products Co. (Destin) is a company engaged in the manufacture of valves, pumps and flow controllers. Destin is a highly competitive company, having at its helm Steve Abbott, John Scott and Roland Guidry and is a local success story in Destin, Florida.
Recently, Destin has come under fire by way of significantly shrinking gross margins due to price pressure from competition. The production of valves has contributed about 24% of the company’s revenues and has comfortably retained a 35% gross margin. Pumps, which contribute 55% of total revenue, have been under siege recently because of similar pumps in the market that are being offered at lower prices. Destin had to cut the sale price of their pumps to compete, bringing their gross margins from their projected 35% to paltry 22%. Flow meters contribute about 21% of revenues and even when prices were raised by 12.5%, no competitor seemed to take an interest in the segment of the market.
Because of the price pressure from competitors on the largest product of Destin, its managers have taken a look at the way they look at costs, particularly the manner of determining over head costs per unit. Traditionally, Destin took standard material and direct labor costs and allocated overhead costs by simply taking the sum of all overhead costs and then dividing it by the total run labor hours per product. This cost accounting method was modified by the company’s controller to reflect the use of machine hours instead of labor hours as a determinant in allocating overhead costs. However, John Scott wants to use transactions-based cost allocation as a method of determining costs, as he had learned in a previous seminar.
Executive Summary
Destin uses a traditional approach to determining the manufacturing cost and adds a 35% margin to determine the selling price. This is shown in the table below. What management found alarming is the decline in the gross margin of the pumps due to a reduction in selling price. It was also unclear to them why flow controllers were an uninhibited market; despite the market accepting higher prices for it (Destin increased its selling price by 12.5%). This cost accounting practice was later modified to reflect the use of machine hours instead of labor hours as a determinant in allocating overhead costs. Finally, the method of calculating how overhead can be allocated based on transactions is conducted. This method uses the same numbers for direct variable costs (material cost, direct labor, and set-up labor) but allocates overheads based on the number of transactions done in doing a particular activity. A summary of the three cost approaches are shown below.
The analysis shows that allocating costs using transactions-based allocations provides a better picture of manufacturing costs. This approach would yield a higher net income at the current selling prices (despite flow controllers being sold at a loss) of 819, 592 compared to the current net income of 548,592. Price-wise, targeting a 35% gross margin over all products provides new prices for the products (valves at retained at 57.78/unit, pumps at 53.34/unit from 81.86/unit and flow controllers at 162.28/unit from 97.07/unit.
Table 1 Cost Accounting Calculations for Destin Bras
Destin uses a traditional approach to determining the manufacturing cost and adds a 35% margin to determine the selling price. This is shown in the table below. What management found alarming is the decline in the gross margin of the pumps due to a reduction in selling price. It was also unclear to them why flow controllers were an uninhibited market; despite the market accepting higher prices for it (Destin increased its selling price by 12.5%). The revenue contributions, computed standard costs, projected selling price, gross margin and actual selling price and gross margin are shown in the table below.
Table 1 Revenue Contributions and Traditional Cost Accounting Calculations
This cost accounting practice was later modified to reflect the use of machine hours instead of labor hours as a determinant in allocating overhead costs. The table below summarizes the modifications.
Table 2 “Modern” Cost Accounting Calculations
The total cost numbers vary from the standard calculation procedure; however, these calculations are not very different from the first approach, in that it uses the number of units of a particular feature as a determinant to allocate overhead costs. In this calculations, the volume-driving determinant is machine hours spent, hence the inclusion of depreciation under the total overhead costs.
When transaction-based cost allocation is used, different results are seen. The table below uses the same numbers for direct variable costs (material cost, direct labor, and set-up labor) but allocates overheads based on the number of transactions done in doing a particular activity. The summary of transactions was provided and the results based on those transactions are summarized below.
Table 3 Transactions-Based Cost Accounting
The table below summarizes the impact of cost accounting on gross margins. With the traditional method of allocating overhead costs, all three products contribute positively to gross margin, with pumps providing 43% of total gross margin, followed by valves and then flow controllers. Modifying the cost allocation strategy shows that pumps still contribute most but the contribution of valves is not as high as the standard practice. If transactions-based cost accounting methods were used, the contribution to gross margin now shows that pumps provide the largest while flow meters have a negative effect on gross margins.
Table 4 Gross Income and % Contribution of Three Cost Accounting Calculations
Finally, the gross income calculations show that gross margin for Destin would increase by 757 thousand if the new selling price of transactions based costs plus 35% margin were used.
