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Cost Accounting Case #2 Destin Brass

Destin Brass Products Co. manufactures three items: valves, pumps and flow controllers (FC's). All three items are used in water purification systems. Destin faces stiff competition in the pump market with no design advantage that would make their pumps more desirable. A meeting was held due to declining profits caused by a lower price Destin was able to charge for pumps and having budgeted pumps sales to account for 55% of company revenues. A proposal was put forth to modify how the company allocates it's overhead costs to the three items it produces.

The company currently uses a standard costing method based on direct labor dollars. This method finds the standard cost per units of valves to be $37.56, pumps $63.12, and FC's $56.50. If the company were to switch to Activity-Based Costing (ABC) the cost per units for valves would be $47.17, pumps $51.64, and FC's $74.22 (Exhibit 1). This is an increase of 20.37% for valves, a decrease of 22.23% for pumps, and an increase of 35.38% for FC's. The company has also calculated unit costs separating the overhead rates for receiving and shipping of materials from other overhead costs. This revised unit cost results in an increase of 23.35% for valves from standard, a decrease of 7.07% for pumps from standard and a decrease in FC's of 17.81% from standard. The revised unit costs are still not close to the costs using the ABC method. The differences are a 3.89% decrease in valves, a 14.15% decrease in pumps and a increase of 35.38% in FC's (Exhibit 3).

The differences' are a result of how overhead is being allocated. The revised unit costs allocated all other overhead based on machine hour. This method applies the same amount of overhead to a unit cost of a pump as to a unit cost of a valve, while applying very little overhead to FC's. When the actual production process is analyzed, the number of transactions required to manufacture FC's is shown to be as high as 78% of materials handling when actual machine hours used is only 7%. Also by using the ABC method, the important pump cost will show a gross margin profit of 36% and show that valves are actually contributing only 18% towards gross profits, not the 35% seen using the standard method.

Since Destin is not seeing any noticeable competition in the FC market, price could easily be raised the $3 to produce the 35% profit margin budgeted for (Exhibit 3). In the valve market Destin only has one customer. To have valve unit costs produce the 35% gross profit margin, an increase in price of $10 will have to be made (Exhibit 3). This will have to be carefully considered prior to execution. With such a drastic price increase, the one customer may go elsewhere for valves. The company could also look to expand it's customer base for valves, increasing the numbers of production runs, and help increase profit margins. If Destin were to

no longer produce valves, overhead costs for machine depreciation and maintenance would have to be absorbed by the remaining two product lines, ultimately making their unit costs higher and less profitable.

Destin may consider maximizing profit in the low competition FC market to higher then 35% to offset the less profitable valve market. To stay competitive in the pump market, Destin should look at cutting costs of components used. A single pump takes 5 components to produce at a cost of $20, while FC's take twice as many for only $2 more in material costs.

Even if Destin changes to the ABC method, there will be no change in the net income of the company during the following month. This is assuming no change in production, sales, costs and activities. The ABC method does not actually change the total overhead costs, it only changes how those costs are allocated. The company has $460,000 in total overhead in it's revised unit costs calculations, and after using the ABC method the company still has $460,000 (Exhibit 1) in overhead costs. Since all other costs were assumed to be unchanged, net income cannot be changed.