Video Options Ltd. manufactures two types of DVD players: standard and deluxe. It attempts to set selling prices based on a 50% markup on manufacturing costs to cover selling and administrative expenses and to earn an acceptable return for shareholders. Bill Merch, vice president—Marketing, is confused because the numbers provided by Terry Green, controller, indicate that standard DVD players should be priced at $150 per unit and deluxe DVD players at $300 per unit. The competition is selling comparable models for $145 and $525, respectively. Merch informs Green that there must be something wrong with the job costing system. He had recently attended a seminar where the speaker stated that “All production costs are not a function of how many units are produced, or of how many labor hours, labor dollars, or machine hours are expended.” He knows that the company uses direct labor dollars as its only cost allocation base. Bill thinks that perhaps this explains why the product costs and, therefore selling prices, are so different from those of the competitors. Currently, the costs per unit are determined as follows: Standard Deluxe Direct Materials $30.00 $50.00 Direct Labor 17.50 37.50 Factory Overhead $52.50 $112.50 Manufacturing cost per unit $100.00 $200.00 Factory overhead is currently applied using a plantwide rate based on direct labor cost. This year’s rate was computed as follows: Budgeted Factory Overhead Direct labor Support $300,000 Machine Support 400,000 Setup Costs 200,000 Design Costs 100,000 Total $1,000,000 Budgeted direct labor $333,333 Budgeted Factory Overhead rate $1,000,000/$333,333=300% of direct labor dollars Green, knowing that you had recently studied ABC in your cost accounting course, employs you as a consultant to determine what effect its usage would have on the product costs. You first gathered the following data: Standard Deluxe Total Units Produced 10,000 2000 12000 Direct labor hours 60,000 40,000 100,000 Machine hours 30,000 20,000 50,000 Machine setups 200 800 1,000 Design changes 50 200 250 From the data that you gathered, determine the best allocation base for each of the four components of factory overhead. Compute an overhead rate for each of the four components. Determine the new unit cost for standard and deluxe models using ABC. Why are the product costs so dramatically different when ABC is used? Would Video Options’ selling prices be closer to those of the competition if ABC were used?
Cost-Volume-Profit Analysis
Cost Volume Profit (CVP) analysis is a cost accounting method that analyses the effect of fluctuating cost and volume on the operating profit. Also known as break-even analysis, CVP determines the break-even point for varying volumes of sales and cost structures. This information helps the managers make economic decisions on a short-term basis. CVP analysis is based on many assumptions. Sales price, variable costs, and fixed costs per unit are assumed to be constant. The analysis also assumes that all units produced are sold and costs get impacted due to changes in activities. All costs incurred by the company like administrative, manufacturing, and selling costs are identified as either fixed or variable.
Marginal Costing
Marginal cost is defined as the change in the total cost which takes place when one additional unit of a product is manufactured. The marginal cost is influenced only by the variations which generally occur in the variable costs because the fixed costs remain the same irrespective of the output produced. The concept of marginal cost is used for product pricing when the customers want the lowest possible price for a certain number of orders. There is no accounting entry for marginal cost and it is only used by the management for taking effective decisions.
Video Options Ltd. manufactures two types of DVD players: standard and deluxe. It attempts to set selling prices based on a 50% markup on
Merch informs Green that there must be something wrong with the
Currently, the costs per unit are determined as follows:
| Standard | Deluxe | |
| Direct Materials | $30.00 | $50.00 |
| Direct Labor | 17.50 | 37.50 |
| Factory Overhead | $52.50 | $112.50 |
| Manufacturing cost per unit | $100.00 | $200.00 |
Factory overhead is currently applied using a plantwide rate based on direct labor cost. This year’s rate was computed as follows:
| Budgeted Factory Overhead | |
| Direct labor Support | $300,000 |
| Machine Support | 400,000 |
| Setup Costs | 200,000 |
| Design Costs | 100,000 |
| Total | $1,000,000 |
| Budgeted direct labor | $333,333 |
| Budgeted Factory Overhead rate | $1,000,000/$333,333=300% of direct labor dollars |
Green, knowing that you had recently studied ABC in your cost accounting course, employs you as a consultant to determine what effect its usage would have on the product costs. You first gathered the following data:
| Standard | Deluxe | Total | |
| Units Produced | 10,000 | 2000 | 12000 |
| Direct labor hours | 60,000 | 40,000 | 100,000 |
| Machine hours | 30,000 | 20,000 | 50,000 |
| Machine setups | 200 | 800 | 1,000 |
| Design changes | 50 | 200 | 250 |
- From the data that you gathered, determine the best allocation base for each of the four components of factory overhead.
- Compute an overhead rate for each of the four components.
- Determine the new unit cost for standard and deluxe models using ABC.
- Why are the product costs so dramatically different when ABC is used?
- Would Video Options’ selling prices be closer to those of the competition if ABC were used?
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