Analysis and Report by Destin Brass Products Company - Case Study Example

Contents Contents 2 Executive Summary 2 Report 3 Exhibits 6 Exhibit Product Costs by Activity-based Costing (Bruns, 1997; Rebecca, 2004) 6 Exhibit2. Costs Comparison (Bruns, 1997; Rebecca, 2004) 7 Exhibit 3. Net Income Comparisons (Bruns, 1997; Rebecca, 2004) 7 References 8 Executive Summary Destin Brass Products Co. is a manufacturer of valves, pumps, and flow controllers. Destin enjoys good positioning in the non-specialized valve market. Pumps are a major component of the company’s revenues, and the company has no unique design advantage. As competitors have been reducing prices on pumps, there was not much choice for Destin but to match lower prices or lose its positioning in the market. Destin had virtually no competition in the flow controller market. The Company was faced with the challenge of adapting to new costing methods for remaining competitive. Recommendations include adoption of activity-based costing. Unit costs by activity-based costing are $47.17 for valves, $51.64 for pumps, and $74.22 for flow controllers. The differences in cost are due to activity and not production volume. As opposed to the length of production run, receiving and handling material, packing and shipping, and engineering orders influenced costs. Whenever overhead costs could not be traced directly to product lines, they were allocated on the basis of transactions, as transactions caused costs to be incurred. The new costs provide a better competitive positioning in comparison to the traditional and modern costing methods. Potential gross margins are 18.37, 3.45, and 23.54 percent respectively for valves, pumps, and flow controllers based on ABC unit costs. Report Destin Brass Products Co. is a manufacturer of valves, pumps, and flow controllers. Valves account for 24 percent of company revenues, pumps account for 55 percent of revenues, and flow controllers account for 21 percent of revenues. The Company was formed by Abbott Guidry and John Scott in 1984. Roland Guidry is the president of the company, Peggy Alford, the controller, John Scott, the manufacturing manager, and Steve Abbott is the sales and marketing manager. Valves are of high cost as precise machining was involved. Destin enjoyed lesser competition in the non-specialized valve market. A single production run was responsible for all monthly production of valves. Pump manufacture had a similar manufacturing process. There are five components that are machined and assembled. Competitors have been reducing prices on pumps. Pumps are a major component of the company’s revenues, and the company had no unique design advantage. There was not much choice for Destin but to match lower prices or lose its positioning in the market. This had resulted in fall of gross margins to 22 percent, which was below the company’s target gross margin of 35 percent. Guidry and Alford were not sure how competitors were making profits at current prices. Flow controllers had manufacturing process similar to valves. Destin had virtually no competition in the flow controller market. Even a raise of prices by 12.5 percent had no effect on demand. Destin had a traditional cost accounting system based on measurements of direct and indirect costs, and assumptions of production and sales activity. In the method, each unit of product was charged for material and labor cost. Material cost was based on input prices. Labor cost was $16 per hour. Overhead was assigned in two stages. First, overhead was assigned to production, and then overhead costs were assigned to production based on production labor cost. Every $1 of run labor cost caused $4.39 of overhead. An alternative was to forego the overhead cost allocation altogether, and charged as period expenses. However, this kind of direct cost accounting was dangerous. The revised standard unit costs were based on a more modern view of allocating costs. Material related overhead was allocated to each product line based on the cost of material. Set-up labor cost was allocated to each product line. Machine hours were substituted for labor dollars for the remaining factory overhead. The revised standard costs for pumps were $4 below the present standard, and the gross margin was 27 percent compared to the current 22 percent. It was better than the traditional method, but further improvements were desirable. It was decided to make estimates for activity-based costing. Unit costs by activity-based costing (see exhibit 1) are $47.17 for valves, $51.64 for pumps, and $74.22 for flow controllers. A cost comparison (see exhibit 2) indicates a 20.37 percent change from the Standard unit costs and -3.89 percent from Revised unit costs for valves; a -22.23 percent change from the Standard unit costs and -14.15 percent from Revised unit costs for pumps; and a 23.87 percent change from the Standard unit costs and 35.38 percent from Revised unit costs for flow controllers. The differences in cost are due to considerations of activity and not production volume. As opposed to the length of production run, receiving and handling material, packing and shipping, and engineering orders influenced costs. Whenever overhead costs could not be traced directly to product lines, they were allocated on the basis of transactions, as transactions caused costs to be incurred. For example, a product that required three times as many transactions was allocated three times as much of the overhead costs. Product costs for material, direct labor, and set-up labor were the same as revised unit costs. Other overhead costs were based on transactions. Recommendations include adoption of activity-based costing. As discussed earlier, and demonstrated in exhibit 2, the new costs provide a better competitive positioning in comparison to the traditional and modern costing methods. Destin enjoys good positioning in the valve and flow controller market, and higher costs would not affect demand. On the other hand, reduced pump costs were much desired for staying competitive. Net income comparisons have been illustrated in exhibit 3. Potential gross margins achievable are 18.37, 3.45, and 23.54 percent respectively for valves, pumps, and flow controllers based on ABC unit costs. This is in comparison to gross margins of 35, 22.32, and 41.79 percent respectively for valves, pumps, and flow controllers based on standard unit costs. The lower margins are caused by lesser difference between actual selling price and unit costs. Exhibits Exhibit 1. Product Costs by Activity-based Costing (Bruns, 1997; Rebecca, 2004) Valves Pumps Flow Controllers Total Production units 7500/mo 12500/mo 4000/mo Machine OH 113400 113400 43200 270000 Eng OH 20000 30000 50000 100000 Packaging & shipping OH 2100 14100 43800 30000 Maintenance OH 10500 17400 2100 30000 Total OH 146000 174900 139100 460000 OH/unit 19.47 13.99 34.78 Material 16.00 20.00 22.00 Receiving & material handling OH 7.68 9.60 10.56 Set-up labor 0.02 0.05 0.48 Run labor 4.00 8.00 6.40 ABC unit costs 47.17 51.64 74.22 Exhibit 2. Costs Comparison (Bruns, 1997; Rebecca, 2004) Valves Pumps Flow Controllers Standard unit costs 37.56 63.12 56.50 Revised unit costs 49.00 58.95 47.96 Percentage change 23.35 -7.07 -17.81 ABC unit costs 47.17 51.64 74.22 Percentage change from Standard 20.37 -22.23 23.87 Percentage change from Revised -3.89 -14.15 35.38 Exhibit 3. Net Income Comparisons (Bruns, 1997; Rebecca, 2004) Valves Pumps Flow Controllers Standard unit costs 37.56 63.12 56.50 Target selling price 57.78 97.10 86.96 Planned gross margin 35 35 35 Planned net income 151650 424750 121840 Actual selling price 57.78 81.26 97.07 Actual gross margin 35 22.32 41.79 ABC unit costs 47.17 51.64 74.22 Planned gross margin 35 35 35 ABC selling price 63.68 69.72 100.19 Percentage change from Standard 9.26 -39.28 13.21 Actual selling price 57.78 81.26 97.07 ABC actual gross margin 18.37 3.45 23.54 References Bruns, W. (1997). Destin Brass Products Co. Harvard Business School (9-190-089). 1-10. Rebecca, F. (2004). Cost Accounting Case Study. Available: http://www.cookieshouse.com/schoolprod/destinbrass.html. Last Accessed 19 February 2010. Read More