Statement of the Problem
1. Destin Bras Products Co. (Destin) founded by Steve Abbott, John Scott and Roland Guidry and is a local success story in Destin, Florida and is in the business of producing valves, pumps and flow controllers.
2. Destin is facing stiff competition. Currently Destin’s revenues come from valves (24%) earning the company a 35% gross margin, pumps (55%) which has been observed to be weakening to a gross margin of only 22% and flow controllers (21%) even after increasing prices by 12.5% have not been attacked by competitors. With no technical patents or other advantages, Destin has no idea how competitors can remain profitable by selling at very low prices for pumps or be uninterested in what looks like a lucrative market for flow controllers.
3. What corrective action should Destin take to enable it to match prices, retain market share and protect long-term viability? Particularly, how should Destin allocate cost overheads to reflect true manufacturing costs?
Executive Summary
Destin uses a traditional way of allocating overhead costs to determine unit costs. This was later modified to reflect the dominance of machines in the production process. However, the cost accounting methods used by Destin does not explain why the markets are behaving differently, for one the pumps market has been attacked while the seemingly lucrative segment of flow controllers remain uninhabited.
Using transactions-based cost allocation showed how traditional cost accounting overstates unit manufacturing costs. This is the reason why competitors can price their products lower than Destin, because they are following the transactions-based approach. The contribution of valves was found out not to be of primary importance in terms of contribution to gross margin, valves are. Flow controllers, which were thought to have large gross margins, have negative contribution to total net income. With the proper cost allocating technique, we can see that the net income of Destin is in fact 819 thousand instead of 548 thousand.
At the new selling prices, Destin will make a net income of 1.57 million, 757 thousand higher than the transactions-based cost accounting calculations using its original selling price.
Analysis
Destin maintains a very traditional way of allocating overhead costs to determine unit costs. This technique has been popular because previously, labor has been the only determinant for the cost of manufacturing products. The labor-based cost allocation approach has been replaced by machine usage based cost allocation because of the dominance of machines in the current manufacturing process. However, these approaches follow a variable-cost ran strategy. Current practices involve transactions, or the number of processes, to allocate overhead costs to determine unit prices.
Destin’s approach is to determine direct material and labor costs and then add a 35% margin to determine the selling price. This method of calculation yields the following unit results.
Table 1 Destin Traditional Cost Accounting Calculations
Table 2 Destin Machine-Usage Based Cost Accounting Calculations
The same production numbers, when subjected to a transactions-based cost allocation approach, yields different numbers. We are given the allocations from the case, as shown below.
Table 3 Destin Transactions-Based Cost Accounting
What do the results show us? Firstly, it shows that the traditional method of allocating overhead costs grossly overstates unit manufacturing costs. This is the reason why competitors can price their products lower than Destin, because they are following the transactions-based approach.
Secondly, the contribution of valves is watered down by the importance of pumps in terms of gross margin contribution. Flow controllers, which were thought to have large gross margins, have negative contribution to total net income. With the proper cost allocating technique, we can see that the net income of Destin, is in fact 819 thousand instead of 548 thousand.
Table 4 Gross Income and % Contribution of Three Cost Accounting Calculations
Because the playing field has changed, Destin has no choice but to compete. In the pumps market, it can do so by lowering its price to 53.64 per unit and still retain a 35% gross margin. In the flow controllers market, it should sell each unit at 162 to make a 35% margin. It should discontinue selling these products if the price goes below 105.48 per unit. Valves should be sold at its current price, since it is above the new proposed price for valves.
Table 5 Destin New Product Prices Strategy
At the new selling prices, Destin will make a net income of 1.57 million, 757 thousand higher than the transactions-based cost accounting calculations using its original selling price.
Table 6 Destin Net Income Calculation using Transaction-based Cost Accounting
