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Ronald Guidry, Steve Abbott and John Scott established the Destin Brass Products Co. in 1984 at Destin in Florida. Later, Peggy Alford joins the team as an accountant. The company manufacturing three water purification equipments such as valves, pumps and flow controllers*. Out of three Destin's products, pumps profit margin is decreasing with time because of competitive market and tedious design.
The company's 55% revenue comes from sales of pumps. The company's profit slipped again lower than last month, a meeting was held to postmodern for better understand competitive trends and to develop new appropriate strategies. Mr. Alford, an accountant of the Destin Company explained during the meeting that the company is currently practicing the traditional cost accounting system. Where all overheads costs applied to production costs and the overhead costs are apply to product using the direct labor costs. The advantage of using the system, it is very simple to do the calculations and all the data meets for preparing financial reports and tax returns. The standard per unit cost of valves $37.56, pumps $63.12 and flow/co* $56.50 and the planned gross margin are 35% for each product as mentioned above but the actual gross margin of last month are as follows 35% for valves, 22% for pumps and 42% for flow/co (Exhibit 3 of assignment note).
Alford further explained that the company has also calculated using of more modern or revised cost accounting system unit cost excluding the material related overhead (receiving and materials handling) from other (manufacturing) overhead cost. Received unit costs of valves $49.00, pumps $58.95 and flow/co $47.96 (Exhibit 4 of assignment note). If the company uses ABC+ (ABC= Activity Based Costing)+ accounting system to view of the proper way to allocate activity based costs using this system; in first stage, the costs are trace to activities and then these costs are trace in second stage to the products that used the activities. Using ABC system, the cost per unit of valves $37.50, pumps $48.79 and flow controls $100.91 respectively.
Overview of the profit margin comparing the above three accounting system. i.e. Traditional accounting system profit margin of valves 35%, pumps 22% and flow/co. 42%. Revised profit margin of valves 15%, pumps 27% and flow/co. 51%. Activity Based Costing profit margin of valves 35%, pumps 40% and flow/co -4%. Therefore, if the company will use ABC accounting system the pumps profit margin will improve and an indication to increase price of flow/co further as Steve has recently raised flow/co price by 12% that does not affect demand and sales. The advantage of using ABC in Destin Co. because of multi-product company where lager overhead exists and ABC is more accurate to trace costs to activities performed the products. ABC system will allow strategic evaluation of products design and making decision of pricing. There will be no changes in total expenditure and net incomes of the company.
The Destin Brass Production Co. manufacturing water purification equipments and it grew speedily due to demands and soon become sole supplier of valves to its customers. The company extends products line and started production of pumps and flow controllers. Destin's quality of valves is good and because of high demand, the company maintaining 35% profit margin and 24% of company revenues comes from valves.
Flow controllers planned gross margin kept as 35%, later 121/2 % profit margin increased but the demand does not affect because Destin had almost no competition. Even further reasonable increase in profit margin does not affect demands, and 21% company revenue comes from flow controllers.
Pump market was large and 55% company revenue comes from pump. Initially, company planned gross margin was 35% but due to highly competitive market pressure the profit margin slipped to 22% even though continues pressure to decrease price further to sustain in the market.
The company's two founders and accountant had puzzled and tensed to see the sales report of pump during the meeting. They decided to look in details the company pricing system and make new strategies to stay competitive in the market and finding possibilities to reduce price of pump.
Traditional Cost Accounting
The company is currently practicing the traditional cost accounting system where all overheads costs applied to production costs and the overhead costs is applied to product using direct labor dollars. The cost per unit of valve to be $37.56, pump $63.12 and flow/co $56.50. Planned and actual gross margin of valves was same i.e. 35%, flow/co planned gross margin kept 35% and actual gross margin was increases to 42% and finally, pumps planned gross margin kept 35% but actual gross margin slipped to 22% (Exhibit 1 of assignment note). After an analysis of actual production process, it was noticeable that 78% transactions required for receiving and handling for flow/co while 3% and 19% required for valves and pumps respectively. Engineering overhead costs for valves and pumps is 20% and 30% respectively, where 50% allotted for flow/co (Exhibit 5 of assignment note). All three products are different and it cannot be accurate to distribute the overhead-related cost equally among the products. It will be difficult for Destin Co. to sell pumps using traditional accounting system in the competitive market because it does not give accurate manufacturing cost of a product. On other hand, the competitors might manufacture only pumps or using another accounting system that gives accurate manufacturing price of pumps. Therefore, competitor's unit selling price of pump is lesser than Destin's pump. The advantage of using the system it is very simple to do the calculations and all the data meets for preparing financial reports and tax returns. Limitations of the system it does not give manufacturing details. So manufacturing per unit cost of pumps increases while adding the overhead related cost applies similar to all products. Without knowing the actual manufacturing cost, it is difficult to keep the price competitive.
Result, the company miscalculates the manufacturing cost of the pumps and the price of pumps should be either too higher or too lower with respect to competitors. This is just because of using traditional cost accounting system and the allocation of uniform overhead-related costs on products. For Destin Co. this is not suitable accounting system where they cannot get the details reports of manufacturing and overhead costs.
Revised Cost Accounting
The revised cost accounting system gives more detail information of the production cost of products as comparison of traditional accounting system. In this system, the material related overhead cost and other overhead costs are separate (Exhibit 4 of assignment note). Material related overhead cost applicable instead of direct labor cost and not even labor cost of production run. The revised standard cost of valves $49.00, pumps $58.95 and flow/co was $47.96. If we compare traditional vs revised accounting system for Destin Co. products, it would be noticeable that the profit margin of pumps was increase by 5%, valves profit margin slipped down to 20% and for flow/co. increases by 9%. 20% profit margin decrease in valves will be a huge revenue loss for company where 5% profit margin increased is not so significant. Using of Revised accounting system of Destin Co is not so profitable (please see Exhabit-1 for the comparison of traditional Vs revised cost accounting).The advantage of the system is still simple and have the details information needs to do the financial/ tax reporting.
Account Based Costing (ABC)
The focus of the discussion during the meeting is how the competitors keep the price less of pumps where the manufacturing process of pumps is better in Destin Co. Destin Co. has to think and make strategy to reduce price of pump to stay competitive in the market.
If Destin Co. has decided to implement ABC accounting system, using of ABC accounting system provides more accurate cost and product process information as compare to above mentioned two accounting system. Destin Co produces heterogeneous products using same technology so ABC accounting system is more appropriate to measure cost to activities performed to produce different products. It will also allow strategic evaluation of products design and making decision of pricing. There will be no changes in total expenditure and net incomes of the company. The change in reallocation of overhead costs on an individual product manufacturing cost that will help to improve profit margin of pumps and to keep the price competitive.
In comparison with ABC and traditional accounting system profit margin of valves and pumps are same, and profit margin of flow/co slipped (please see Exhibit 2 & 3) . So the company's strategies should not to change the price of valves. The profit margin of pumps price was 40%, so possibilities to reduce 5% price (please see Exhabit-7). Therefore, price of pumps will be reducing from $81.26 to $75.06 and still the company maintain 35% profit margin and stay competitive in the market.
On another side, the company has to spend on R&D and engineering to develop new design and better technology of pumps. Price game does not work in long run for a company; a large segment of customers believe in buying good products and expecting good sales and services after purchasing product. Using ABC system the profit margin of flow/co slipped to -4% on $97.07 i.e. actual selling price. If the company would like to maintain profit margin of flow/co by 35% then need to increase price by $155.25 (please see Exhibit-8). The new price of flow/co can be justified that there was no competitors in the market and Destin is the sole manufacturer and distributer of flow/co.
The Destin Brass Production Co. should implement the ABC accounting system to calculate and allocate accordingly the overhead costs of products. No need to change the selling price of valves and if the company continues to keep 35% of gross margin then needs to reduce price of pumps to $75.06. Finally, the company needs to increase further price of flow/co to $155.25 to maintain 35% profit margin.
The Destin Co. is making heterogeneous products (valves, pumps and flow/co) under a shelter and using the parts to assembled new product (pump). In this scenario, the company should be flexible while planning or setting gross margin of a product (pumps) to stay competitive in the market. The company has opportunity to compensate the loss of pumps sells while increasing price of other products (valve and flow/co). These two products do not have bottleneck competitors and in totality the company able to maintain, average 35% gross profit. The individual product's (pump) profit margin should be secondary concern. The price of a product depends on various factors.