Managerial Accounting: Creating Value in a Dynamic Business Environment Hilton,
Traditional versus Activity-Based Costing Systems
PROBLEM:
Madison Electric Pump Corporation manufactures electric pumps for commercial use. The company produces three models, designated as regular, advanced, and deluxe. The company uses a job-order cost accounting system with manufacturing overhead applied on the basis of direct-labor hours. The system has been in place with little change for 25 years. Product costs and annual sales data are as follows:
Regular Model
Advanced Model
Deluxe Model
Annual sales (units).....
20,000
1,000
10,000
Product costs:
Direct material.....
$ 20
$ 50
$ 84
Direct labor.....
20 (1 hr. at $20)
40 (2 hr. at $20)
40 (2 hr. at $20)
Manufacturing overhead*.
170 (1 hr. at $170)
340 (2 hr. at $170)
340 (2 hr. at $170)
Total product cost.....
$210
$430
$464
Manufacturing-overhead budget:
Depreciation, machinery.....
$2,960,000
Maintenance, machinery.....
240,000
Depreciation, taxes, and insurance for factory.....
600,000
Engineering.....
700,000
Purchasing, receiving and shipping.....
500,000
Inspection and repair of defects.....
750,000
Material handling.....
800,000
Miscellaneous manufacturing overhead costs.....
590,000
Total.....
$7,140,000
Direct-labor budget:
Regular model:
20,000 hours
Advanced model:
2,000 hours
Deluxe model:
20,000 hours
Total
42,000 hours
For the past 10 years, the company's pricing formula has been to set each product's target price at 110 percent of its full product cost. Recently, however, the regular-model pump has come under increasing price pressure from offshore competitors. The result was that the price on the regular model has been lowered to $220.
The company president recently asked the controller, "Why can't we compete with these other companies? They're selling pumps just like our regular model for $212. That's only two bucks more than our production cost. Are we really that inefficient? What gives?"
The controller responded by saying, "I think this is due to an outmoded product-costing system. As you may remember, I raised a red flag about our system when I came on board last year. But the decision was to keep our current system in place. In my judgment, our product-costing system is distorting our product costs. Let me run a few numbers to demonstrate what I mean."
Getting the president's go-ahead, the controller compiled the basic data needed to implement an activity-based costing system. These data are displayed in the following table. The percentages are the proportion of each cost driver consumed by each product line.
Product Lines
Activity Cost Pool
Cost Driver
Regular Model
Advanced Model
Deluxe Model
I: Depreciation, machinery
Machine time
39%
13%
48%
Maintenance, machinery
II: Engineering
Engineering hours
47%
6%
47%
Inspection and repair of defects
III: Purchasing, receiving, and shipping
Number of material orders
47%
8%
45%
Material handling
IV: Depreciation, taxes, and insurance for factory
Factory space usage
42%
15%
43%
Miscellaneous manufacturing overhead
Required:
1.) Compute the target prices for the three pump models, based on the traditional, volume-based product-costing system.
2.) Compute new product costs for the three products, based on the new data collected by the controller. Round to the nearest cent.
3.) Calculate a new target price for the three products, based on the activity-based costing system. Compare the new target price with the current actual selling price for the regular model pump.