Question:
Decision Making and Distorted Costs
ACE Industries is a manufacturer of machined parts located in midwestern United States. Its primary customers are suppliers to the automobile industry, although it has diversified its customer base in recent years to reduce its dependence on any one sector. It is considered to be a well-run and profitable company.
In July, the company appointed Stephen Smale as Chief Financial Officer. Smale had a reputation for having a strong financial focus and a ruthless approach to cost cutting. His appointment was the result of a change in strategy along these lines that coincided with the downturn in the economy. His view was that financial success was attained by focusing on products that were highly profitable rather than being a full-line producer. Thus, he imposed a requirement that any product that had a budgeted profit margin (product line profit divided by product line revenue) below 10 percent be dropped.
The product line managers are currently preparing their budgets for the next year. This will be the first year that Smale's approach to running the business (requiring a minimum 10 percent profit margin) will be tested. Product line profits are computed by first deducting estimated direct labor and direct material costs from estimated product revenues. Manufacturing overhead is then allocated to products based on estimated direct labor costs. Corporate overhead is not allocated to products and is not included in the 10 percent requirement. Estimated product line revenues and direct costs follow:
|
|
|
Direct
|
Direct
|
|
|
|
Material
|
Labor
|
|
Product
|
Revenue
|
Costs
|
Costs
|
|
A
|
$270,000
|
$ 70,000
|
$20,000
|
|
C
|
165,000
|
65,000
|
12,000
|
|
E
|
305,000
|
145,000
|
28,000
|
Estimated annual manufacturing overhead is $240,000.
Required
a. Assuming all products are sold and all revenues and costs are as budgeted, what will operating profit t be next year?
b. Based on the criterion set by the CFO, which product(s) will the company drop?
c. Regardless of your answer to requirement (b), assume the company decided to drop product E. The controller estimates that if product E is dropped, manufacturing overhead will decline to $208,000. Assuming all other product line revenues and costs are incurred as budgeted, what will operating profit t be?
d. The company again goes through the exercise with the two products to see if any should be dropped. Based on the criterion set by the CFO, which product(s) will the company drop?
e. Regardless of your answer to requirement (d), assume the company decides to drop product C. The controller estimates that if product C is dropped, manufacturing overhead will decline to $190,000. Assuming all other product line revenues and costs are incurred as budgeted, what will operating profit t be? What will the profit t margin be?
f. What is the cause of what you observe? Is reported profit t margin a useful way to make the decision of what products to keep in this situation