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Question 1. Product Costs per Unit

Material Direct Labor Overhead (439% of Direct Labor $) * Standard unit cost $37.56 $63.12 *Overhead Machine depreciation $270,000 Set-up labor 2,688 Receiving 20,000 Materials handling 200,000 Engineering 100,000 Packing and shipping 60,000 Maintenance 30,000 Total overhead $682,688 Total run labor = 9,725 hours $16 = $155,600. Overhead rate = $682,688 / 155,600 = 439% Valves $16.00 4.00 17.56 Pumps $20.00 8.00 35.12 Flow Controllers $22.00 6.40 28.10 $56.50

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Question 2. Estimated Current Contribution Margin for Products

Valves Revenue $57.78 Variable CostsMaterial only 16.00 Contribution 41.78 or Assume Labor is Variable (case says only direct material is short-run variable). Run Labor 4.00 8.00 6.40 Set-up Labor ~.02 ~.05 ~.48 4.02 8.05 6.88 Contribution $37.76 $53.21 $68.19
Flow Pumps Controllers $81.26 $97.07 20.00 22.00 61.26 75.07

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Question 3. Revised Product Unit costs per More Modern View

Valves $16.00
Flow Pumps Controllers $20.00 $22.00 9.60 .05 8.00 21.30 $58.95 10.56 .48 6.40 8.52 $47.96

Material Material Related Overhead (48%)* 7.68 Set-up Labor .02 Direct Labor 4.00 Other overhead ($42.59 per machine hr)** 21.30 Revised standard cost $49.00

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*Material Related Overhead Receiving $ 20,000 Material Handling 200,000 Total $220,000 Overhead Allocation Rate on Materials Cost: $220,000 / $458,000 = 48% of materials cost **Other Overhead on Machine-Hour Basis Machines Depreciation $270,000 Engineering 100,000 Packing and Shipping 60,000 Maintenance 30,000 Total $460,000 Overhead Allocation Rate = $460,000 / 10,800 hours = $42.59 per machine hour

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Question 4. Products Costs Using Activity Based Costing

Val ve s Per Unit $16.00 4.00 T ot al 7,500 $120,000. 30,000. Pumps Per Unit $20.00 8.00 T ot al 12,500 $250,000. 100,000. Fl ow Control l e rs Per Unit $22.00 6.40 .

M at erial Labor Overhead: Set -up Receiving M at l. Handling Pack & Ship Engineering M aint enance M ach. Dep r. T ot al Overhead T ot al Cost

Tot al M ont h T ot al 4,000 24,000 unit s $88,000. $458,000. 25,600. 155,600. 1,920. 15,600. 156,000. 43,800. 50,000. 2,100. 20,000. $289,420. $403,020. 2,688. 20,000. 200,000. 60,000. 100,000. 30,000. 270,000. $682,688. $1,296,288.

0.02 0.08 0.80 0.32 2.66 1.40 12.50 $17.78 $37.78

128. 600. 6,000. 2,400. 20,000. 10,500. 93,750. $133,378. $283,378.

0.05 0.30 3.04 1.11 2.40 1.39 12.50 $20.79 $48.79

640. 3,800. 38,000. 13,800. 30,000. 17,400. 156,250. $259,890. $609,890.

0.48 3.90 39.00 10.95 12.50 0.53 5.00 $72.36 $100.76

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Question 5. Comparisons of Reported Income Between Methods

There will be no difference. Each month reflects two different methods of assigning the same actual costs to the three products. The total results for the company will be identical.

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Question 6. Comparison of Product Profitability Under Three Costing Systems

Actual Selling Price Standard Cost Gross Margin Gross Margin % Revised Cost Gross Margin Gross Margin % ABC Cost Gross Margin Gross Margin %

Valves $57.78
37.56 20.22 35% 49.00 8.78 15% 37.78 20.00 35%

Pumps $81.26
63.12 18.14 22% 58.95 22.31 27% 48.79 32.47 40%

Flow Controllers $97.07 56.50 40.57 42% 47.96 49.11 51% 100.76 (3.69) (4%)

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The total reported results are the same for the company under the three methods. The accounting allocations for individual product lines change the gross margins significantly. Product line profitability changes most significantly for flow controllers under ABC, dropping from the highest gross margin product to a loser. Given the "complexity" reflected in Exhibit 3 for flow controllers, the activity/transactions costing system bears out the higher proportion of costs. Therefore it is "better" than other systems. Also, although there could be differences in some cost allocations such as engineering and maintenance, 100% of the costs are allocated on a reasonable resource consumption basis using ABC.

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Question 7. Using ABC to Re-evaluate JIT Purchasing Policy for Flow Controllers
Receiving and inbound handling is $140,000 ($20,000 + .6 x $200,000). Under a "just-in-case" or JIC practice where all components for a month's Flow Controller production will be purchased together, the total receiving and material handling costs will be only $14,000 (1/10 the cost). Some assumptions will be necessary for calculating an inventory storage and carrying cost charge. The total cost of flow controller components purchased each month is $88,000. Assume uniform production during the month so that the average inventory cost is $44,000 (50% x $88,000). Assume carry costs are 100% per year, including a capital charge for space, space costs (maintenance, etc.), handling costs (labor, etc.), carrying costs (insurance, taxes, etc.), and cost of funds. Applying a monthly carrying cost rate of 8.5% (100% / 12 months), the monthly storage and carrying cost is $3,740 (.085 x $44,000).

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Recap
Just-in-Time Costs: Just-in-Case Costs: Receiving & material handling $14,000 Carrying cost ~4,000 Net savings per month using "JIC" $140,000

18,000 122,000

If TBM can reduce the receiving and in-bound material handling costs, there is a potential net savings of almost $1.5 million per year ($122,000 12) by using just-in-case purchasing. If we assume the $140,000 total costs are fixed, then there are no savings. But, if all costs are totally fixed, who cares about any allocation scheme anyway?

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Drop Flow Controllers?

Adding flow controllers to the product line (to use idle capacity?) doubled the manufacturing complexity (4 or 5 components versus 10 components). Is this a reasonable thing to do in our factory? If flow controllers were dropped, how much cost savings could be realized? This question cannot be answered by ABC which is not based on a variable cost and fixed cost dichotomy. For example, one half the engineering costs are subjectively assigned to flow controllers. Will $50,000 of engineering cost be avoided if flow controllers were dropped? This does not change the conclusion that on a fully allocated basis, flow controllers have a negative gross margin, let alone providing any bottom line profit.

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Or Raise Selling Price?

Given the no-competition market for flow controllers, perhaps the selling price could be increased gradually, but who knows. Who are the customers? What do they want? How much will they pay? Given the uncertainty expressed by management in this market, there seems to be little harm in this pricing strategy, assuming management wishes to keep the product line after seeing the ABC results. But, one must note that the higher the selling price, the more likely TBM will see some competition and/or reduced demand.

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What About Pumps?

The selling price for flow controllers increased more than 12% this past month while the selling price for pumps decreased more than 16%. The ABC analysis indicates that pumps still have the highest gross margin (40%) at the actual selling price. The gross margin would be 35% at a price of $75.06, which would allow still further price cuts of $6.20 per unit. Given the commodity pricing pressure on pumps, and if 35% is really TBM's necessary gross margin before SG&A expenses to earn an adequate rate of return, then a further 5% decrease to approximately $75 can be made without harming the target gross margin. This assumes the ABC costs per unit do not change.

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Cost Reduction (Re-engineering) for Pumps?

There is a lot of buyer power in this market, so TBM must undertake cost reduction and re-engineering programs to be the low cost producer. The case says pumps require less precision manufacturing than valves. Pumps involve only one more component than valves. Could cost reductions be possible? There are approximately 58 workers on board and average wage (plus benefits) is $16 per hour. At 25% benefits, an approximate wage rate is $13 per hour, which is on the high side for industrial manufacturing jobs along the Mexican border. Perhaps less skilled machinists could be used on the pumps (and flow controllers)? Although automation is touted by management, direct labor represents 12% of the total manufacturing costs. Again, some cost savings may be possible. Also, eight hours for a set-up?

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How are Valves Doing?

Apparently, the one valve customer is pleased with our quality and competitive price. Competitors are not attempting price cuts. The case implies that automation and efficient production processes are helping control costs and efficiency. But is it good strategy for TBM to be dependent on a single customer for valves? The ABC gross margin is 35% for valves so no action seems necessary to raise or lower prices. A question for management: Is there no growth in this market? Evidently, the company makes pumps and flow controllers to fill out the production capacity. Can we really continue long-run with 24% of sales in a no-growth market with a single customer?