Chapter 11, Problem 28P

1.

To determine

Discuss the reasons behind the loss of money. Explain the strategic insight that provides the knowledge of activities, their costs, and customer linkages. Describe the changes that is needed to correct the deficiency on the observation made by Mr. B

Explanation of Solution

The reason behind the P Work’s loss of money is unaware activities made by each customer. The huge customer places small, specialized orders, and requiring machine parts with high care. The activity and activity caused cost increases because of the frequent orders and specialized nature of the parts. The plant wide amount spreads these costs over all customers, so the smaller customers are supporting the large one. The customer will start searching for alternative sources if the cost of the smaller jobs increases. Increase in number of jobs from large customers affects the capability to produce the parts for its smaller regular customers on a timely basis. The management could have priced the job inversely, if it was aware of the activities generated by each customer, its activities and activity caused costs and its linkage to jobs and customers. Likewise, instead of large customer the management emphasizes smaller customer which is led by knowledge of activities, their costs, and linkages to output and customers. The activity and cost information is provided by an activity-based costing system which allows managers to see the relationships between external and internal activities.

2.

To determine

Calculate the unit price.

Explanation of Solution

Calculate the unit price.

Traditional Pricing:

Particulars	Small customer	Large Customer
Prime cost	$ 14,000	$ 1,600
Overhead	$ 28,600(1)	$ 2,860(2)
Total cost (a)	$ 42,000	$ 4,460
Unit produced (b)	1,000	100
Unit cost (a/b)	$ 42.60	$ 44.60
Markup	10.65 (3)	11.15 (4)
Current Prices	$ 53.25	$ 55.75

Table (1)

Working Note (1): Calculate the overhead of small customer.

$\begin{array}{c}\text{Overhead of large Customer}=\left(\begin{array}{l}\text{Overhead rate of large customer job}\\ \times \text{Machine hours of large customer job}\end{array}\right)\\ =\left(\$14.30\times 2,00\right)\\ =\$2,860\end{array}$

Working Note (2): Calculate the overhead of large customer.

$\begin{array}{c}\text{Overhead of large Customer}=\left(\begin{array}{l}\text{Overhead rate of large customer job}\\ \times \text{Machine hours of large customer job}\end{array}\right)\\ =\left(\$14.30\times 200\right)\\ =\$2,860\end{array}$

Working Note (3): Calculate the markup of small customer.

$\begin{array}{c}\text{Markup of Small Customer}=\left(\text{Unit cost}\times \text{0}\text{.25}\right)\\ =\$42.60\times 0.25\\ =10.65\end{array}$

Working Note (4): Calculate the markup of large customer.

$\begin{array}{c}\text{Markup of large Customer}=\left(\text{Unit cost}\times \text{0}\text{.25}\right)\\ =\$44.60\times 0.25\\ =11.15\end{array}$

3.

To determine

Calculate the unit price that would be charges to each customer by assuming that the overhead is assigned using an ABC approach. Identify whether the large customer paying less than the cost of production per unit or not. Explain the way this conclusion will be affected if the sales support activity is traced to jobs.

Explanation of Solution

Calculate the pool rates.

Activity	Calculations	Total
Setups	$\frac{\text{\$209,000}}{\text{1,045 hours}}$	$200 per setup hour
Engineering	$\frac{\text{\$151,200}}{\text{630 hours}}$	$240 per engineering hour
NC programming	$\frac{\text{\$130,400}}{\text{815 hours}}$	$2160per programming hour
Machining	$\frac{\text{\$100,000}}{\text{50,000 hours}}$	$ 2 per machine hour
Reworks	$\frac{\$101,400}{1,300\text{ defective units}}$	$78 per unit
Inspecting	$\frac{\text{\$23,000}}{\text{230 hours}}$	$100 per inspection hour

Table (2)

Notes: the activity capacities are calculated by multiplying the average job usage by number of jobs.

Calculate the hours.

Activity	Calculations	Hours
Setups	$\left(3\times 15\right)+\left(10\times 100\right)$	1,045
Engineering	$\left(2\times 15\right)+\left(6\times 100\right)$	630
NC programming	$\left(1\times 5\right)+\left(8\times 100\right)$	815
Machining	$\left(2,000\times 15\right)+\left(200\times 100\right)$	50,000
Reworks	$\left(20\times 15\right)+\left(10+100\right)$	1,300
Inspecting	$\left(2\times 15\right)+\left(2\times 100\right)$	230

Table (3)

Calculate the unit price.

Table (4)

P Works will discover that the major share of this cost is being caused by the large customer, if sales support is traced to individual products. The activity driver is the number of orders, yielding the following rates:

Calculate the sales support rate.

$\begin{array}{c}\text{Sales Support Rate}=\frac{\text{Sales support}}{\text{Number of orders}}\\ =\frac{\$80,000}{115}\\ =\$695.65\text{ per order}\end{array}$

Assignment to small customers:

$\begin{array}{c}\text{Small Customers}=\left(\begin{array}{l}\text{Sales support rate}\\ \times \left(\begin{array}{l}\text{Quarterly jobs }\\ \text{of small customers}\end{array}\right)\end{array}\right)\\ =\$695.65\times 15\\ =\$10,435\end{array}$

Assignment to large customers:

$\begin{array}{c}\text{Large Customers}=\left(\begin{array}{l}\text{Sales support rate}\\ \times \left(\begin{array}{l}\text{Quarterly jobs }\\ \text{of large customers}\end{array}\right)\end{array}\right)\\ =\$695.65\times 100\\ =\$69,565\end{array}$

It strengthens the observation that the unit cost for the larger customer is higher than the selling price. Large customer purchases 10,000 units which are added to about $6.96 of cost to each unit. This brings the unit product cost to $83.96.

4.

To determine

Compute the quarterly profit that is presently being earned and the amount that would be earned by P Works sold only to the small customers.

Explanation of Solution

Calculate the current profit.

Particulars	Amount ($)
Sales (5)	1,356,250
Cost of goods sold	1,085,000
Gross profit	271,250
Less: Selling expenses	80,000
Income before taxes	191,250

Table (5)

Working Note (5): Calculate sales.

$\begin{array}{c}\text{Sales}=\left(\begin{array}{l}\left(\begin{array}{l}\text{Current prices }\\ \text{of small customers}\end{array}\right)\\ \times \left(\text{Number of units}\right)\end{array}\right)+\left(\begin{array}{l}\left(\begin{array}{l}\text{Current prices }\\ \text{of large customers}\end{array}\right)\\ \times \left(\text{Number of units}\right)\end{array}\right)\\ =\left(\$53.25\times 15,000\right)+\left(\$55.75\times 10,000\right)\\ =\$1,356,250\end{array}$

Working Note (6): Calculate the cost of goods sold.

$\begin{array}{c}\text{Cost of goods sold}=\left(\begin{array}{l}\left(\begin{array}{l}\text{Units cost of}\\ \text{ small customer}\end{array}\right)\times \text{Number of units}\\ +\left(\left(\begin{array}{l}\text{Units cost of}\\ \text{large customer}\end{array}\right)\times \text{Number of units}\right)\end{array}\right)\\ =\left(\$42.60\times 15,000\right)+\left(\$4.60\times 10,000\right)\\ =\$1,085,000\end{array}$

To calculate the profit related with a small customer strategy, first we must calculate the unit product cost and price.

Calculate the unit product cost and price.

Table (6)

Note:

• Engineering activity requires only one step. Presently there are six steps and each step requires 105 hours. The cost of one step is $25,200$\left(\frac{\$151,000}{6\text{steps}}\right)$. The activity rate is $240 per hour $\left(\frac{\$25,200}{105\text{hours}}\right)$. The unused activity capacity cost is reported in the financial statement as a separate item, it should not be assigned to the products.
• The revised demand needs only one step. The activity rate for that activity rate is $100 per hour $\left(\frac{\$23,000}{230\text{hours}}\right)$.

Prepare the income statement for small customer strategy.

Small Customer strategy
Income statement
Particulars	Amount ($)
Sales	$656,250
Less: Cost of goods sold	$525,000
Gross profit	$131,250
Less: Cost of unused activity
Engineering	$13,200
Inspecting	$18,000
Adjusted gross profit	$100,050
Less: sales support	$32,000
Income before taxes	$68,050

Table (7)

Notes to the above statement:

• Sales are $656,200$\left(\$26.25\times 25,000\right)$.
• Cost of goods sold $525,000$\left(\$21.00\times 25,000\right)$.
• Cost of unused engineering activity is $13,200$\left(\$240\times \left[\left(6\times 100\right)-\left(5\times 105\right)-\left(2\times 10\right)\right]\right)$ and for inspecting activity is $18,000$\left(\$100\times \left[\left(2\times 100\right)-\left(2\times 10\right)\right]\right)$.
• Sales support needs two steps and each step costs $16,000. Therefore, sales support expenses are $32,000$\left(\$16,000\times 2\right)$.

5.

To determine

Identify the change in the strategy that would be recommended.

Explanation of Solution

P Works functions in a small section of the industrial value chain.  Moreover, it has very little seller power mainly comparative to the Fortune 500 Company. The president stated concern regarding the growing prices as he was frightened that he might lose the huge customer’s business however yet, the company cannot pay off to carry on selling at the same price. It is only a matter of time waiting for the remaining smaller customers discard the firm.

The profit advantage exposed in Requirement 4 is imaginary. It is about to vanish as the smaller customers will not endure to fund the large customer. The advantage of P Works ostensibly lays with the small to medium-sized firms that like P work and the accessibility of its location. Even if the big firm decides to a price increase, it appears risky to place so many eggs in one basket (40% of the business assignable to one customer). Assume that two years from now, the big firm merely dumps P Work. In this time, it may be hard to reconstruct the customer relations that might be required to continue as a feasible business.

P Works would be well directed to reconstruct its relationships with the smaller firms although it is quite promising to do so.