Product Costing, Cost Estimation, and Decision Making
I don’t understand this. Last year [year 1], we decided to drop our highest-end Red model and only produce the Yellow and Green models, because the cost system indicated we were losing money on Red. Now, looking at the preliminary numbers, our profit is actually lower than last year and it looks like Yellow has become a money loser, even though our prices, volumes, and direct costs are the same. Can someone please explain this to me and maybe help me decide what to do next year?
Robert Dolan
President & CEO
Dolan Products
Dolan Products is a small, family-owned audio component manufacturer. Several years ago, the company decided to concentrate on only three models, which were sold under many brand names to electronic retailers and mass-market discount stores. For internal purposes, the company uses the product names Red, Yellow, and Green to refer to the three components.
Data on the three models and selected costs follow:
This year (year 2), the company only produced the Yellow and Green models. Total overhead was $650,000. All other volumes, unit prices, costs, and direct labor usage were the same as in year 1. The product cost system at Dolan Products allocates manufacturing overhead based on direct labor-hours.
Required
- a. Compute the product costs and gross margins (revenue less cost of goods sold) for the three products and total gross profit for year 1.
- b. Compute the product costs and gross margins (revenue less cost of goods sold) for the two remaining products and total gross profit for year 2.
- c. Should Dolan Products drop Yellow for year 3? Explain.
a.
Compute the product costs and gross margins for the three products and total gross profit for year 1.
Answer to Problem 62IC
The values of product costs and gross margins for the three products and total gross profit for Year 1 are as follows:
Particulars | Red | Yellow | Green |
Product Cost | $ 978,571 | $ 914,286 | $ 907,143 |
Gross Profit | ($ 228,571) | $ 85,714 | $ 592,857 |
Gross margin | $200,000 | $300,000 | $700,000 |
Table: (1)
Explanation of Solution
Gross margin: Gross margin is calculated by subtracting the cost of goods sold (COGS) from the revenue of the business. It defines the profit earned only because of the production of the goods. It does not account for indirect expenses. It is also known as gross profit.
Total product cost: It includes direct materials cost, direct labor cost, and manufacturing overhead (MOH).
Compute the total product cost:
For Product Red:
For Product Yellow:
For Product Green:
Thus, the values of the total cost for Product Red, Yellow and Green are $978,571, $914,286 and $907,143 respectively.
Compute the gross margins and gross profit for the three products and total gross profit for year 1:
Year 1 | ||||
Particulars | Red | Yellow | Green | Total |
Sales Revenue: | $ 750,000 | $ 1,000,000 | $ 1,500,000 | $ 3,250,000 |
Less: Variable cost | $ 550,000 | $ 700,000 | $ 800,000 | $ 2,050,000 |
Gross Margin | $ 200,000 | $ 300,000 | $700,000 | $ 1,200,000 |
Less: Fixed manufacturing overhead | $ 428,571 | $ 214,286 | $ 107,143 | $ 750,000 |
Gross profit | ($ 228,571) | $ 85,714 | $ 592,857 | $ 450,000 |
Table: (2)
Compute the gross margin:
For Product Red:
For Product Yellow:
For Product Green:
Thus, the value of gross margin for the Product Red, Yellow and Green are $200,000, $300,000 and $700,000 respectively.
Compute the gross profit:
For Product Red:
For Product Yellow:
For Product Green:
Thus, the values of gross profit for the Product Red, Yellow and Green are ($228,571), $85,714 and $592,857 respectively.
Working note 1:
Compute the variable cost For Product Red:
Working note 2:
Compute the variable cost For Product Yellow:
Working note 3:
Compute the variable cost For Product Green:
Working note 4:
Compute the fixed manufacturing overhead For Product Red:
Working note 5:
Compute the fixed manufacturing overhead For Product Yellow:
Working note 6:
Compute the fixed manufacturing overhead For Product Green:
b.
Compute the product costs and gross margins for the two products and total gross profit for year 2.
Answer to Problem 62IC
The product costs and gross margins for the two products and total gross profit for year 2 are as follows:
Particulars | Yellow | Green |
Total Cost | $ 1,133,333 | $ 1,016,667 |
Gross Profit | $ (133,333) | $ 483,333 |
Gross margin | $ 300,000 | $ 700,000 |
Table: (3)
Explanation of Solution
Gross margin: Gross margin is calculated by subtracting the cost of goods sold (COGS) from the revenue of the business. It defines the profit earned only because of the production of the goods. It does not account for indirect expenses. It is also known as gross profit.
Total product cost: It includes direct materials cost, direct labor cost, and manufacturing overhead (MOH).
Compute the total product costs For Product Red:
Thus, the value of total production costs for Product Green is $978,571.
Compute the total product costs For Product Yellow:
Thus, the value of total production costs for Product Yellow is $914,286.
Compute the total product costs For Product Green:
Thus, the value of total production costs for Product Green is $907,143.
Compute the gross margins for the three products and total gross profit for year 2:
Year 2 | |||
Particulars | Yellow | Green | Total |
Sales Revenue | $ 1,000,000 | $ 1,500,000 | $ 2,500,000 |
Less: Variable cost | $ 700,000 | $ 800,000 | $ 1,500,000 |
Gross Margin | $ 300,000 | $ 700,000 | $ 1,000,000 |
Less: Fixed manufacturing overhead | $ 433,333 | $ 216,667 | $ 650,000 |
Gross profit | $ (133,333) | $ 483,333 | $ 350,000 |
Table: (4)
Compute the gross margin for Product Red:
Thus, the value of the gross margin for Product Red is $200,000.
Compute the gross margin for Product Yellow:
Thus, the value of the gross margin for Product Yellow is $300,000.
Compute the gross margin for Product Green:
Thus, the value of the gross margin for Product Green is $700,000.
Compute the gross profit for Product Red:
Thus, the value of gross profit for Product Red is ($228,571).
Compute the gross profit for Product Yellow:
Thus, the value of gross profit for Product Yellow is $85,714.
Compute the gross profit for Product Green:
Working note 1:
Compute the variable cost for Product Red:
Working note 2:
Compute the variable cost for Product Yellow:
Working note 3:
Compute the variable cost for Green:
Working note 4:
Compute the fixed manufacturing overhead for Product Red:
Working note 5:
Compute the fixed manufacturing overhead for Product Yellow:
Working note 6:
Compute the fixed manufacturing overhead for Product Green:
c.
Explain should the product Yellow be dropped or not for year 3.
Explanation of Solution
No, the product Yellow should not be dropped for Year 3. Product Red was dropped for the production for year 2. The total manufacturing overhead was reduced by $100,000. The implication of a reduction of $100,000 might seem favorable as well. Reduction in cost would directly result in more profit.
But, in the situation given, reduction in total manufacturing overhead by eliminating the product Red has reduced the gross profit and gross margin as well. Gross profit was declined to $483,333 from $592,857 resulting in an 18% decrease in gross profit.
For Year 1 the total cost, gross profit and gross margin for Products Red, Yellow and Green are as follow:
Particulars | Red | Yellow | Green | Total |
Total cost | $ 978,571 | $ 914,286 | $ 907,143 | $ 2,800,000 |
Gross profit | ($ 228,571) | $ 85,714 | $ 592,857 | $ 450,000 |
Gross margin | $ 200,000 | $ 300,000 | $ 700,000 | $ 1,200,000 |
Table: (5)
For Year 2 the total cost, gross profit and gross margin for Products Red, Yellow and Green are as follow:
Particulars | Yellow | Green | Total |
Total Cost | $ 1,133,333 | $ 1,016,667 | $ 2,150,000 |
Gross Profit | $ (133,333) | $ 483,333 | $ 350,000 |
Gross margin | $ 300,000 | $ 700,000 | $ 1,000,000 |
Table: (6)
Due to the elimination of product Red total gross profit has been reduced to $350,000. The reduction of $100,000 implies the reduction in cost as a whole. The total gross profit has declined by 18%.
But, to evaluate both the years separately the total impact on the cost and profit is negligible and there is a difference of 4% in gross margin with respect to total cost.
Hence, it is not advisable to drop the Product Yellow.
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Chapter 6 Solutions
FUNDAMENTALS OF COST ACCOUNTING
- Wayne Johnson, president of Banshee Company, recently returned from a conference on quality and productivity. At the conference, he was told that many American firms have quality costs totaling 20 to 30 percent of sales. He, however, was skeptical about this statistic. But even if the quality gurus were right, he was sure that his companys quality costs were much lowerprobably less than 5 percent. On the other hand, if he was wrong, he would be passing up an opportunity to improve profits significantly and simultaneously strengthen his competitive position. The possibility was at least worth exploring. He knew that his company produced most of the information needed for quality cost reportingbut there never was a need to bother with any formal quality data gathering and analysis. This conference, however, had convinced him that a firms profitability can increase significantly by improving qualityprovided the potential for improvement exists. Thus, before committing the company to a quality improvement program, Wayne requested a preliminary estimate of the total quality costs currently being incurred. He also indicated that the costs should be classified into four categories: prevention, appraisal, internal failure, or external failure. He has asked you to prepare a summary of quality costs and to compare the total costs to sales and profits. To assist you in this task, the following information has been prepared from the past year, 20x5: a. Sales revenue, 15,000,000; net income, 1,500,000. b. During the year, customers returned 90,000 units needing repair. Repair cost averages 1 per unit. c. Four inspectors are employed, each earning an annual salary of 60,000. These four inspectors are involved only with final inspection (product acceptance). d. Total scrap is 150,000 units. Of this total, 60 percent is quality related. The cost of scrap is about 5 per unit. e. Each year, approximately 450,000 units are rejected in final inspection. Of these units, 80 percent can be recovered through rework. The cost of rework is 0.75 per unit. f. A customer cancelled an order that would have increased profits by 150,000. The customers reason for cancellation was poor product performance. g. The company employs three full-time employees in its complaint department. Each earns 40,500 a year. h. The company gave sales allowances totaling 45,000 due to substandard products being sent to the customer. i. The company requires all new employees to take its three-hour quality training program. The estimated annual cost of the program is 30,000. Required: 1. Prepare a simple quality cost report classifying costs by category. 2. Compute the quality cost-to-sales ratio. Also, compare the total quality costs with total profits. Should Wayne be concerned with the level of quality costs? 3. Prepare a pie chart for the quality costs. Discuss the distribution of quality costs among the four categories. Are they properly distributed? Explain. 4. Discuss how the company can improve its overall quality and at the same time reduce total quality costs. 5. By how much will profits increase if quality costs are reduced to 2.5 percent of sales?arrow_forwardThe president of Poleski would like to know the effect that each of the following suggestions for improving performance would have on contribution margin per unit, sales needed to break even, and projected net income for next year. Each change should be considered independently. Reset the Data Section to its original values after each suggestion is analyzed. Fill in the table following the suggestions with the results of your analysis. a. The president suggests cutting the products price. Since the market is relatively sensitive to price, . . . a 10% cut in price ought to generate a 30% increase in sales (to 156,000 units). How can you lose? b. The sales manager feels that putting all sales personnel on straight commission would help. This would eliminate 77,000 in fixed sales salaries expense. Variable sales commissions would increase to 2.00 per unit. This move would also increase sales volume by 30%. c. Poleskis head of product engineering wants to redesign the package for the product. This will cut 1.00 per unit from direct materials and 0.50 per unit from direct labor, but will increase fixed factory overhead by 100,000 for additional depreciation on the new packaging machine. The package redesign would not affect sales volume. d. The firms consumer marketing manager suggests undertaking a new advertising campaign on Facebook. This would cost 30,000 more than is currently planned for advertising but would be expected to increase sales volume by 30%. e. The production superintendent suggests raising quality and raising price. This will increase direct materials by 1.00 per unit, direct labor by 0.50 per unit, and fixed factory overhead by 110,000. With improved quality, . . . raise the price to 18.50 and advertise the heck out of it. If you double your current planned advertising, Ill bet you can increase your sales volume by 30%.arrow_forwardDanna Wise, president of Tidwell Company, recently returned from a conference on quality and productivity. At the conference, she was told that many American firms have quality costs totaling 20 to 30% of sales. The quality experts at the conference convinced her that a company could increase its profitability by improving quality. However, she was of the opinion that the quality of Tidwell Company was much less than 20%probably more in the 4 to 6% range. However, because the potential for increasing profits was so great if she was wrong, she decided to request a preliminary estimate of the total quality costs currently being incurred. She asked her controller for a summary of quality costs, with the costs classified into four categories: prevention, appraisal, internal failure, or external failure. She also wanted the costs expressed as a percentage of both sales and profits. The controller had his staff assemble the following information from the past year, 20X1: a. Sales revenue, 37,240,000; net income, 4,000,000. b. During the year, customers returned 40,000 units needing repair. Repair cost averages 9 per unit. c. Twelve inspectors are employed, each earning an annual salary of 80,000. The inspectors are involved only with final inspection (product acceptance). d. Total scrap is 200,000 units. Of this total, ninety percent is quality related. The cost of scrap is about 10 per unit. e. Each year, approximately 800,000 units are rejected in final inspection. Of these units, seventy-five percent can be recovered through rework. The cost of rework is 1.80 per I unit. f. A customer cancelled an order that would have increased profits by 600,000. The customers reason for cancellation was poor product performance. g. The company employs 10 full-time employees in its complaint department. Each earns 48,600 a year. h. The company gave sales allowances totaling 180,000 due to substandard products being sent to the customer. i. The company requires all new employees to take its 4-hour quality training program. The estimated annual cost of the program is 120,000. Required: 1. Prepare a simple quality cost report classifying costs by category. 2. Compute the quality cost-sales ratio. Also, compare the total quality costs with total profits. Should Danna be concerned with the level of quality costs? 3. Prepare a pie chart for the quality costs. Discuss the distribution of quality costs among the four categories. Are they properly distributed? Explain. 4. Discuss how the company can improve its overall quality and at the same time reduce total quality costs. 5. By how much will profits increase if quality costs are reduced to 3% of sales?arrow_forward
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