You are a Consultant for the professional service firm, BUSI 2083 LLP. Your firm specializes in providing a wide variety of internal business solutions for different clients. It is your first day on the job and a Manager asks you for some help with a client in the Technology & Entertainment sector. Eager to please on your first day, you start reading the background information provided by the Manager.
4D Entertainment, a division of Wave of the Future Corporation, manufactures two large-screen television models: the Zenith, which has been produced since 2008 and sells for $1,700, and the Pinnacle, a new model introduced in early 2008, which sells for $2,200. Based on the following income statement for the year ended November 30, 2014, senior management at Wave of the Future have decided to concentrate 4D Entertainment’s marketing resources on the Pinnacle model and begin to phase out the Zenith model.
For the Year Ended November 30, 2014
Zenith Pinnacle Total
Sales $30,600,000 $4,400,000 $35,000,000
COGS 19,890,000 3,080,000 22,970,000
Gross Margin 10,710,000 1,320,000 12,030,000
Selling and Admin Expense 8,032,500 925,000 8,957,500
Operating Income $2,677,500 $395,000 $3,072,500
Units Sold 18,000 2,000
Operating Income per Unit Sold $148.75 $197.50
Unit costs for Zenith and Pinnacle are as follows:
Direct Material $540.00 $1,089.00
Zenith (2.5 hours x $18 per hr) 45.00
Pinnacle (7.0 hours x $18 per hr) 126.00
Zenith (8 hours x $25 per hr) 200.00
Pinnacle (5 hours x $25 per hr) 125.00
Other Manufacturing Overhead** 320.00 200.00
Total $1,105.00 $1,540.00
*Machine costs include leasing of the machine, repairs, and maintenance.
** Other manufacturing overhead is allocated on the basis of machine hours at a rate of $40 per machine hour.
4D’s controller, Tina Wesley, is advocating the use of activity-based costing (ABC) and activity based management (ABM), and has gathered the following information about the company’s manufacturing overhead costs for the year ended November 30, 2014.
Units of Cost Driver
Total Activity Costs Zenith Pinnacle
Soldering $1,872,400 1,296,000 214,000
Shipments 1,480,000 1,500 500
Quality Control 1,749,600 54,000 18,000
Purchase Orders 582,400 16,640 4,160
Machine Power 61,600 144,000 10,000
Machine Set-up 414,000 360 100
Total Manufacturing Overhead $6,160,000
Soldering is based on the number of solder points, shipments based on the number of shipments, quality control based on the number of inspections, purchase orders based on the number of PO’s, machine power based on machine hours, machine setups based on the number of setups.
After completing her analysis, Wesley showed the results to Donald Warden, the 4D Entertainment Division President. Warden did not like what he saw. “If you show headquarters this analysis, they are going to ask us to phase out the Pinnacle line, which we have just introduced. This whole costing thing has been a major problem for us. First Zenith was not profitable and now Pinnacle.
“Looking at the ABC analysis, I see two problems. We do many more activities than the ones you have listed. If you had included all activities, maybe your conclusions would have been different. Second, you used number of setups and number of inspections as allocation bases. The numbers would have been different had you used setup hours and inspection hours instead. I know that measurement problems precluded you from using these other cost allocation bases, but at least you ought to make some adjustments to our current numbers to compensate for these issues. I know you can do better. We can’t afford to phase out either product.”
Wesley knew her numbers were fairly accurate. On a limited sample, she had calculated the profitability of Zenith and Pinnacle using different allocation bases. The set of activities and activity rates she had chosen resulted in numbers that approximated closely those based on more detailed analyses. She was confident that headquarters, knowing that Pinnacle was introduced only recently, would not ask 4D Entertainment to phase it out. She was also aware that a sizable portion of Warden’s bonus was based on division sales. Phasing out either product would adversely affect the bonus. Still, she felt some pressure from Warden to do something.
4D Entertainment is unsure of the strategies to properly reflect information for their parent company. The manager would like the following questions addressed as soon as possible:
1. Using activity-based costing (ABC), calculate the profitability of the Zenith and Pinnacle models.
2. Explain briefly why these numbers differ from the profitability of the Zenith and Pinnacle models calculated using 4D Entertainment’s existing costing system.
3. Comment on Warden’s concerns about the accuracy and limitations of ABC.
4. How might 4D Entertainment find the ABC information helpful in managing its business?
5. What should Tiny Wesley do?