Problem 1: Sandy Pat, president of the Pressure Cooker Company, was reviewing the product profitability reports with the management accountant, Youl Gaspar. The following conversation took place:
Sandy: I have been reviewing the product profitability reports. Our high-volume cooker, the C-20, appears to be unprofitable, while some of our lower-volume specialty cooker in the S-30 series appear to be very profitable. These results do not make sense to me. How is the product profits determined?
Youl: First, we identify the revenues associated with each product line. This information comes directly from our sales order system and is extremely accurate. Subsequently, we identify the direct materials and direct labour associated with making each of cookers. Again, this information is very accurate. The final cost that must be considered is factory overhead and this is allocated to the products, based on the direct labour hours employed to assemble the cooker.
Sandy: What about distribution, promotion, and other post-manufacturing costs which can be associated with the product?
Youl: According to generally accepted accounting principles, we expense them in period that they are incurred and do not treat them as product costs.
Sandy: Another thing, you say that you allocate factory overhead according to direct labours. Yet I know that the S-30 series have very low volumes but need extensive engineering, testing, and materials management effort. They are our newer, more complex products. It seems that these sources of factory overhead will end up being allocated to C-20 line because it is the high-volume and therefore high direct labour hour product. Yet the C-20 line is easy to make and requires very little support from our engineering, testing, and materials management personnel.
Youl: I am not too sure. I do know that our approach is similar to which employed by many different types of companies. I do not think we could all be wrong.
problem1. Is Sandy’s concern valid and how may Youl redesigning the cost allocation system to address her concern?
problem2. Identify some of the implementation issues and elaborate on some benefits of new system.