Traditional versus Activity-Based Costing Systems Orange, Inc. manufactures three products for the computer industry: Product Annual Sales (Units) A 8,000 B 15,000 C 4,000 The company uses a traditional, volume-based product-costing system with manufacturing overhead applied on the basis of direct-labour pounds. The product costs have been computed as follows: Product A B C Raw material ??35.00 ??52.50 ??17.50 Direct labour ?16.00 (.8 hr at ?20) ?12.00 (.6 hr at ?20) ?8.00 (.4 hr at ?20) Manufacturing overhead* ?140.00 ?105.00 ?70.00 Total product cost ?191.00 ?169.50 ?95.50 * Calculation of predetermined overhead rate: Manufacturing overhead budget: Machine setup ? 5,250 Machinery 1,225,000 Inspection 525,000 Material handling 875,000 Engineering 344,750 Total ?2,975,000 Direct-labour budget (based on budgeted annual sales): Product A 8,000 ? ?16.00 = ?128,000 Product B 15,000 ? 12.00 = 180,000 Product C 4,000 ? 8.00 = 32,000 Total ?340,000 Predetermined overhead rate = Budgeted overhead ? budgeted direct labour = 875% Orange's pricing method has been to set a target price equal to 150% of full product cost. However, only the product B has been selling at its target price. The target and actual current prices for all three products are the following: Product A B C Product cost ?191.00 ?169.50 ?95.50 Target price 286.50 254.25 143.25 Actual current selling price 213.00 254.25 200.00 Orange has been forced to lower the price of product A in order to get orders. In contrast, Orange has raised the price of Product C several times, but there has been no apparent loss of sales. Orange, Inc. has been under increasing pressures to reduce the price even further on product A. In contrast, Orange's competitors do not seem to be interested in the market for product C. Orange apparently has this market to itself. Required: 1- Is product A the company's least profitable product? 2- Is product C a profitable product for Orange, Inc.? 3- Comment on the reactions of Orange's competitors to the company's pricing strategy. What dangers does Orange. Inc. face? 4- Orange's controller, Medo, recently attended a conference at which activity-based costing systems were discussed. He became convinced that such a system would help Orange's management to understand its product costs better. He got top management's approval to design an activity-based costing system, and an ABC project team was formed. In stage one of the ABC project, each of the overhead items listed in the overhead budget was placed into its own activity cost pool. Then a cost driver was identified for each activity cost pool. Finally, the ABC project team compiled data showing the percentage of each cost driver that was consumed by each product line. These data are summarised as follows: Activity Cost pool Cost Driver Product A B C Machine setup Number of setups 20% 30% 50% Machinery Machine hours 25% 50% 25% Inspection Number of inspections 15% 45% 40% Material handling Raw-material costs 25% 69% 6% Engineering Number of change orders 35% 10% 55% Show how the controller determined the percentages given above for raw-material costs. (Round to the nearest whole percent.) 5- Develop product costs for the three products on the basis of an activity-based costing system. 6- Calculate a target price for each product, using Orange's pricing formula. Compare the new target prices with the current actual selling prices and previously reported product costs. 7- Refer to the new target prices for Orange's three products, based on the new activity-based costing system. Write a memo to the company president commenting on the situation Orange, Inc. has been facing regarding the market for its products and the actions of its competitors. Discuss the strategic options available to management. What do you recommend, and why? 8- Prepare a table showing how Orange's traditional, volume-based product-costing system distorts the product costs of products A, B, and C.
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