Marvelous Metals Co.

ACTIVITY-BASED COSTING and CORPORATE STRATEGY

Marvelous Metals Co. specializes in the production and sale of two machine parts: Part 245A and Part 666B. Historically, the profitability of the company has been tied to Part 245A. In the last two years, however, the firm has been facing intense competition, and its sales of this part have dropped. Much of the competition was from foreign sources, and the general manager was convinced that the foreign producers were guilty of dumping (selling below cost). The following conversation between Ken Larson, general manager, and Martha Jones, marketing manager, reflects the concerns of top management and some possible solutions that were being considered.

Martha: "I just received a call from one of our major customers concerning Part 245A. He said that a sales representative from another firm had offered the part at $20 per unit – that’s $8 less than what we ask."

Ken: "Good Heavens! It's costing over $20 just to produce that part, not to mention selling and admin. costs! I don't see how these companies can afford to sell it so cheaply. I'm not convinced that we should meet the price. Perhaps a better strategy is to emphasize producing and selling more of Part 666B. Our margin is high on that product, and we have virtually no competition for it."

Martha: "You may be right. I think we can increase the price of 666B significantly and not lose business. I called a few customers to see how they would react to a 25 percent increase in price, and they all said that they would still purchase the same quantity as before."

Ken: "It sounds promising. However, before we make a major commitment to Part 666B, I think we had better explore other possible explanations. I want to know how our production costs compare to our competitors. Perhaps we could be more efficient and find a way to earn a good return on Part 245A."

After his meeting with Martha, Ken requested an investigation of the production costs and comparative efficiency. The controller reported that as far as he could determine, the firm's efficiency was similar to that of other competitors. The controller did mention the possibility of using activity-based costing, a method that might improve product costing. To assist Ken in understanding the production activities and costs associated with the two products, the controller prepared the following data:

Part 245A
Part 666B

Production
90,000
10,000

Selling price
$28.00
$30.00

Manufacturing overhead per unit
$7.53
$9.69

Prime cost (materials & labor) per unit
$12.48
$6.26

Number of production runs
5
25

Material orders received
40
80

Machine hours
18,000
3,000

Direct labor hours
35,000
5,000

Engineering hours
3,000
7,000

Material moves
10
70

Upon examining the data, Ken decided that he wanted to know more about the manufacturing overhead costs since they were such a high proportion of total production costs. Ken was provided the following list of pooled overhead costs and was told that total manufacturing overhead costs were assigned to products using a plant-wide rate based on direct labor hours. The controller also indicated that he had pooled the manufacturing overhead costs on the basis of what he called activity level and driver classification. He indicated to Ken that it may be possible to improve product costing by assigning the costs using each activity pool instead of one grand plant-wide manufacturing overhead pool.

Manufacturing overhead pool:1

Setup costs (use production runs)
$ 200,000

Machine costs
75,000

Receiving costs
210,000

Engineering costs
200,000

Material handling costs
90,000

Total manufacturing overhead
$775,000

1The pools are named for the major activities found within them. All manufacturing overhead costs within each pool can be assigned using a single cost driver (based on the major activity after which the pool is named). In addition to the manufacturing costs shown above, the controller had collected the following information related to total selling and administrative costs:

Selling costs: Packing costs (cost of packing each shipment to customers) $ 5,000 Shipping costs (a function of the total miles shipped) $200,000 Customer service costs (a function of time spent per customer) $ 42,000

Administrative costs $ 75,000

Currently these selling & administrative costs are assigned to each product based on total units produced and sold.

Martha Jones, marketing manager, has supplied the following information regarding the selling costs:

Part 245A Part 666B
Shipments to customers 100 400
Avg. distance of each shipment 100 miles 200 miles
Total customer service hours 1,000 5,000

Ken Larson, general manager, estimates 80% of the administrative costs should be assigned to Part 666B and the remainder to Part 245A. REQUIRED:

1. Using the current costing system, verify the manufacturing overhead cost per unit reported by the controller, using direct labor hours to assign overhead. Also compute the per-unit gross margin for each product and the per-unit net income.

Plant-wide overhead = total manufacturing overhead / total direct labor hours = $775,000 / (35,000 + 5,000) = $19.375/ DL hr

Product 245A manufacturing overhead per unit =($19.375 X 35,000) / 90,000 units = $7.53 per unit
Product 666B manufacturing overhead per unit = ($19.375 x 5,000) / 10,000 units = $9.69 per unit

Product 245A gross margin per unit = selling price – prime cost = $28 – $12.48 = $15.52 per unit

Product 666B gross margin per unit = selling price – prime cost = $30.00 – $6.26 = $23.74 per unit

Product 245A net income per unit = selling price – (prime cost + overhead cost+ selling and administrative costs) = $28 – ($12.48 + $7.53 +3.22 ) = $4.77 per unit

Product 666B net income per unit = selling price – (prime cost + overhead cost +selling and administrative costs) = $30.00 – ($6.26 + $9.69 + 3.22) = $10.83 per unit

*Selling and administrative costs = ($5,000 + $200,000 + $42,000 + $75,000) / 100,000 total units = $322,000 / 100,000 total units = $3.22/ unit

2. After learning of the activity-based costing, Ken asked the controller to prepare a cost analysis using this approach. Compute the unit cost of each product using activity-based costing. Compute the per-unit gross margin and per-unit net income for each Product.

Activity Based Costing
Find Average:
Set up cost = $200,000 / 30 = $6,666.67 per set up
Machine cost = $75,000 / 21,000 = $3.57 per order
Receiving cost = $210,000 / 120 = $1,750 per order received
Engineering cost = $200,000 / 10,000 = $20 per engineering hr
Material handling cost = $90,000 / 80 = $1,125 per material move

Part 245A Part 666B
Direct Materials + Labor $1,123,200 $62,600
Set up costs $33,333.35 $166,666.75
Machine cost $64,260 $10,710
Receiving costs $70,000 $140,000
Engineering costs $60,000 $140,000
Materials handling $11,250 $78,750
Packing cost $1,000 $4,000
Shipping cost $22,222 $177,600
Customer service $7,000 $35,000
Administrative cost $15,000 $60,000
Gross margin $1,396,800 $237,400
Net income $1,112,734.65 ($575,362.75)

Part 245A gross margin per unit= $15.52
Part 666B gross margin per unit= $23.74

Part 245A net income per unit = $12. 36
Part 666B net income per unit = ($57.53)

3. Should the company switch its emphasis from Part 245A to Part 666B? Comment on the general manager's accusation that competitors are dumping.
No, the company should not switch its emphasis to to Part 666B. The setup cost drivers for part 666b are very significant. Furthermore, from the activity based cost analysis, we find the cost per unit of part 245A is $15.64 which for Marvelous Metals is still well below the selling price of $28. It would be fair to assume that the competitor accused of dumping might have similar cost based of activity based costing and they simply recognized this information before Marvelous Metals did, so that they started selling part 245A at a lower price point than $28.00

4. Explain the apparent lack of competition for Part 666B and the willingness of customers to accept a 25 percent increase in price for this product.
We believe the lack of competition is because the activity based cost per unit for part 666B is $87.53 which is well above the $30.00 selling price. There is no competition for this products because other firms are simply choosing not to produce it because of the negative contribution margin the product adds to the company’s profits. Even with a 25% selling price increase the cost for a part 666b to customers is $37.5 It is fair to assume that the supply for product 666b at a price of $37.5 is just a rare or close to the supply at a selling price of $30.00 and still far off from what the company's relevant quantity range would want to be on the product through activity based costing.

5. Based on the information provided by the activity-based analysis, what strategic actions would you recommend? Translate these recommendations into assumed operating results (showing your assumptions carefully).
We would recommend that Marvelous Metals look into restructuring the process to manufacture Part 666b to reduce or spread out the cost of the cost drivers. They either need to become more lean and reduce cost or entirely stops producing Part 666b and focus on producing part 245A. Per the activity based costing analysis we found that the cost per unit for part 245A is actually below the $20.00 selling price from other competitors. Marvelous Metals can actually undercut the competition by $4.36 and still make break even on cost. This means there is a healthy profit margin on part 245A.