The estimated costs calculated using the activity-based costing method is very different from the existing standard unit costs and the revised unit costs. Exhibit 3 uses the traditional cost allocation system, which allocates all costs based on measures of volume. In the standard unit costs, Destin Brass uses direct labor as the only cost driver, which rarely meets the cause-effect standard wanted in cost allocation. Exhibit 4 is similar to exhibit 3, but instead, 4 uses materials and machine hours as the cost driver instead of just direct labor. The new costs are calculated by using the ABC system, which allocates costs that are caused by non-volume-based cost drivers. After recognizing the overhead activities, costs of overhead resources used for the activities are allocated to the activities using cost drivers.
Then pooled costs of each activity are allocated to products, using the cost drivers. It takes one large overhead cost pool and breaks it down into several pools, which for this company are: receiving and materials handling, machine usage and maintenance, packing and shipping, and engineering. These have a cause-effect relationship with activities and resources that are used. So unlike exhibit 3 and 4, the new system breaks down the overhead costs a lot more. The new estimated costs are more accurate because the amount allocated to each of the overhead activities for each product is more detailed. It shows the percentage of how much each activity is performed on each product.
All 3 products’ unit costs in the new system are different from exhibit 3 and 4. Unit price for valves has a slight change compare to the standard unit price, but for pumps and flow controllers, there is a dramatic change.
Destin Brass are well under their 35% gross margin goal for pumps, and wondering how other companies can sell their pumps for such a low price. They thought the unit costs for pumps is $63.12, when in fact, the more accurate system shows that it’s only $48.81, $14.31 less than the standard unit cost. This inaccuracy is the reason why Destin Brass is having trouble staying competitive with their price on pumps while other companies are able to sell it for a lower price.
The flow controllers have never been a problem for Destin Brass. It seemed to them that they had no competition in that market. Even after raising the prices by 12.5%, demand did not decrease. This is because the more accurate unit cost for flow controllers is actually $100.48, and not $56.50, $43.98 more than what they thought. They have been selling their flow controller at $97.07 each, which is below the unit cost, and that is why no other companies are able to compete in that market.
I think Destin Brass should definitely adjust their selling price for all 3 products. For valves, $58.16 should be their new target-selling price if they want to keep the 35% GM goal, but I think they should make the actual selling price to be a little lower than that. That way they can stay/be more competitive in the valves market while having a GM% that is slightly lower, but still close to the goal.
Selling price for pumps will have to be lowered for them to become competitive in the pumps market, unlike before. $75.09 would be the price they want to sell it at if they want the 35% GM, but the selling could still be slightly lower then that, allowing them to be competitive while still very close to their goal.
Flow controller prices will have to be higher if they want to make a profit from this product. Right now they are making a loss of 4% for each flow controller they sell. If they want to reach the 35% GM mark, they will have to up their cost from $97.07 to $154.58. Just like pumps and valves, price could be a little lower than that, and of course for the same reasons. Yes, this means they will go from having no competition to many competitions in the flow controller market now, but at least they won’t be making a loss every time they sell a flow controller.
In the following month, assuming quantities produced and sold, activities, and costs were all at standard, the profit reported under the new system would be $540,260.00, and under the present system would be $539,180.00. There is only a difference of $1,080. Destin Brass will not see any major
difference in profit in the short run; in this case it’s over a period of one month. But in the long run, they will definitely see major changes in their profits.