Established in 1984, Destin Brass Products Co. had grown to become a significant player in the industry of manufacturing water purification equipment. By identifying a market for water purification valves, Destin Brass quickly built brand awareness and a customer base. Destin Brass developed propriety manufacturing techniques and had a deep understanding of working with brass. This competitive advantage led Destin Brass to add pumps and flow controllers to its product range. Valves, Pumps and Flow Controllers represented 24%, 55% and 21% of company revenues respectively with each having a planned gross margin of 35%. In recent times, manufacturers of pumps had entered into a price war forcing prices down and consequently Destin Brass saw its gross margin on pump sales drop to 22%. At the same time, Destin Brass had found that the price elasticity of demand for Flow Controllers was relatively inelastic, when it increased prices by 12.5% with no effect on demand.
Confused by competitor moves in the price cutting of pumps, the managers at Destin Brass considered if competitors simply didn’t know what they manufacturing costs were, but it was more likely that problems may lie within Destin Brass’s cost accounting system. Destin Brass currently had a traditional cost accounting system in place. The system took into account direct and indirect costs based on production and sales activity. Each produced unit was charged for material cost based on component costs and labour costs based on production run labour times. Overheads were then allocated in a two stage process and yielded standard unit cost of $37.6, $63.1 and $56.5 for valves, pumps and flow controllers respectively.
An alternative to the traditional approach would be to forego overhead cost allocation altogether. Material and set-up labour cost overheads would be allocated to each product line and machine hours would be changed for labour dollars as the basis for allocating the remaining factory overhead. This revised approach reduced pump and flow controller unit costs to $58.9 and $47.9 but increased valve unit costs to $49. A final approach involved more accurately distributing engineering costs and the idea that activity, rather than production volume, drove costs.
This activity based costing (ABC) system would be allocated on the basis of transactions. ABC yielded a standard unit cost of $47.2, $51.6 and $74.2 for valves, pumps and flow controllers respectively. The ABC system suggested that Destin Brass could reduce pump prices dramatically whilst still maintaining healthy margins and at the same time increase flow controller prices to maximise profits. The case illustrates that misused cost accounting systems can have serious strategic implications for a business.