This case compares the traditional single overhead allocation rate to the activity based costing system.
“A dollar of gross profit per briefcase? That’s ridiculous!” roared Art Dejans, president of Carry All, Inc. “Why do we go on producing those standard briefcases when we’re able to make over $15 per unit on our specialty items? Maybe it’s time to get out of the standard line and focus the whole plant on specialty work.”
Mr. Dejans is referring to a summary of unit costs and revenues that he had just received from the company’s Accounting Department:
Carry All produces briefcases from leather, fabric, and synthetic materials in a single plant. The basic product is a standard briefcase that is made from leather lined with fabric. The standard briefcase is a high quality item and has sold well for many years.
Last year, the company decided to expand its product line and produce specialty briefcases for special orders. These briefcases differ from the standard in that they vary in size, they contain the finest synthetic materials, and they are imprinted with the buyer’s name. To reduce labor costs on the specialty briefcases, most of the cutting and stitching is done by automated machines. These machines are used to a much lesser degree in the production of standard briefcases.
“I agree that the specialty business is looking better and better.” replied Sally Henrie, the company’s marketing manager. “And there seems to be plenty of specialty work out there, particularly since the competition hasn’t been able to touch our price. Did you know that Armor Company, our biggest competitor, charges over $50 a unit for its specialty items? Now that’s what I call gouging the customer!”
A breakdown of the manufacturing cost for each of Carry All’s product lines is given below:
Manufacturing overhead is applied to products on the basis of direct labor-hours. The rate of $16 per direct labor-hour is determined by dividing the total manufacturing overhead cost for a month by the direct labor-hours:
Manufacturing overhead cost: $90,000
Direct labor-hours: 5,625 = $16 per direct-labor hour
The following additional information is available about the company and its products:
a) Standard briefcases are produced in batches of 200 units, and specialty briefcases are produced in batches of 25 units. Thus, the company does 50 setups for the standard items each month and 100 setups for the specialty items. A setup for the standard items requires one hour of time, whereas a setup for the specialty items requires two hours of time.
b) All briefcases are inspected to ensure that quality standards are met. A total of 300 hours of inspection time is spent on the standard briefcases and 500 hours of inspection time is spent on the specialty briefcases each month.
c) A standard briefcase requires 0.5 hours of machine time, and a specialty briefcase requires 2.0 hours of machine hours.
d) The company is considering the use of activity-based costing as an alternative to its traditional costing system for computing unit product costs. Since these unit product costs will be used for external financial reporting, all manufacturing overhead costs are to be allocated to products and nonmanufacturing costs are to be excluded from product costs. The activity-based costing system has already been designed and costs allocated to the activity cost pools. The activity cost pools and activity measures are detailed below:
I have included a spreadsheet to assist you in the setup of this problem. Also, this might seem like a lot of information, but analyze the data and try not to read too much into the problem!
1. Using activity-based costing, determine the amount of manufacturing overhead cost that would be applied to each standard briefcase and each specialty briefcase.
2. Using the date computed in (1) above and other data from the case as needed, determine the unit product cost of each product line from the perspective of the activity-based costing system.
3. Within the limitations of the data that have been provided, evaluate the president’s concern about the profitability of the two product lines. Would you recommend that the company shift its resources entirely to production of specialty briefcases? Explain.
4. Sally Henrie state that “the competition hasn’t been able to touch our price” on specialty business. Why do you suppose the competition hasn’t been able to touch CarryAll’s price?