Problem
O'Sullivan Company is an automotive component supplier. O'Sullivan has been approached by Honda of America's Ohio plant to consider expanding its production of part 24Z2 to a total annual quantity of 2,000 units. This part is a low-volume, complex product with a high gross margin that is based on a proposed (quoted) unit sales price of $7.50. O'Sullivan uses a traditional costing system that allocates indirect manufacturing costs based on direct-labor costs. The rate currently used to allocate indirect manufacturing costs is 400% of direct labor costs. This rate is based on the $3,200,000 annual factory overhead cost divided by $800,000 annual direct-labor cost. To produce 2,000 units of 24Z2 requires $5,000 of direct materials and $1,000 of direct labor. The unit cost and gross margin percentage for part 24Z2 based on the traditional cost system are computed as follows:
|
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Per United
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Total
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( divided 2,000)
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|
Direct material
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$5,000
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$2.50
|
|
Direct labor
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$1,000
|
$0.50
|
|
Indirect production (4005 x direct labor)
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$4,000
|
$2.00
|
|
Total cost
|
$10,000
|
$5.00
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|
Sales price quoted
|
|
$7.50
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Gross margin
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$2.50
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|
Gross margin percentage
|
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33.3%
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The management of O'Sullivan decided to examine the effectiveness of their traditional costing system versus an activity-based costing system. The following data have been collected by a team consisting of accounting and engineering analysts:
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Activity center
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Factory overhead costs (annual)
|
|
Quality
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$500,000
|
|
Production scheduling
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$50,000
|
|
Setup
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$700,000
|
|
Shipping
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$300,000
|
|
Shipping administration
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$50,000
|
|
Production
|
$1,600,000
|
|
Total indirect production cost
|
$3,200,000
|
|
Activity Center: Cost Drivers
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Annual Cost-Driver Quantity
|
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Quality: Number of pieces scrapped
|
10,000
|
|
Production scheduling and set up: Number of setups
|
500
|
|
Shipping: Number of containers shipped
|
60,000
|
|
Shipping administration: Number of shipments
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1,000
|
|
Production: Number of machine hours
|
10,000
|
The accounting and engineering team has performed activity analysis and provides the following estimates for the total quantity of cost drivers to be used to produce 2,000 units of part 24Z2:
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Cost Driver
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Cost-Driver Consumption
|
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Pieces scrapped
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120
|
|
Setups
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4
|
|
Containers shipped
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10
|
|
Shipments
|
5
|
|
Machine hours
|
15
|
1. Prepare a schedule calculating the unit cost and gross margin of part 24Z2 using the activity based costing approach. Use the cost drivers given as cost-allocation bases.
2. Based on the ABC results, which course of action would you recommend regarding the proposal by Honda of America? List the benefits and costs associated with implementing an ABC system at O'Sullivan.