Reference no: EM13949407

Pearson Manufacturing is engaged in the production of chemicals for industrial use. One plant specializes in the production of chemicals used in the copper industry.

Two compounds are produced: compound X-12 and compound S-15. Compound X- 12 was originally developed by Pearson's chemists and played a key role in copper extraction from low-grade ore. The patent for X-12 has expired, and competition in this market has intensified dramatically. Compound X-12 produced the highest vol- ume of activity and for many years was the only chemical compound produced by the plant. Five years ago, S-15 was added. Compound S-15 was more difficult to manufacture and required special handling and setups. For the first three years after the addition of the new product, profits increased. In the last two years, however, the plant has faced intense competition, and its sales of X-12 have dropped. In fact, the plant showed a small loss in the most recent reporting period. The plant manager is convinced that competing producers have been guilty of selling X-12 below the cost to produce it-perhaps with the objective of expanding their market shares. The fol- lowing conversation between Diane Woolridge, plant manager, and Rick Dixon, divi- sional marketing manager, reflects the concerns of the division about the future of the plant and its products.

Rick: You know, Diane, the divisional manager is very concerned about the plant's trend. He indicated that in this budgetary environment, we can't afford to carry plants that don't show a profit. We shut one down just last month because it couldn't handle the competition.

Diane: Rick, our compound X-12 has a reputation for quality and value-we have a very pure product. It has been a mainstay for years. I don't understand what's happening.

Rick: I just received a call from one of our major customers concerning X-12. He said that a sales representative from another firm had offered the chemical at $10 per kilogram-about $6 less than what we ask. It's hard to compete with a price like that. Perhaps the plant is simply obsolete.

Diane: No. I don't agree. We have good technology. I think that we are efficient. And it's costing a little more than $10 to produce X-12. I don't see how these com- panies can afford to sell it so cheaply. I'm not convinced that we should meet the price. Perhaps we should emphasize producing and selling more of S-15. Our mar- gin is high on this product, and we have virtually no competition for it. We just recently raised the price per kilogram, and our customers didn't blink an eye.

Rick: You may be right. I think we can increase the price even more and not lose busi- ness. I called a few customers to see how they would react to a 25 percent increase in price, and they all said that they would still purchase the same quantity as before.

Diane: It sounds promising. However, before we make a major commitment to S- 15, I think we had better explore other possible explanations. The market potential is much less than that for X-12. I want to know how our production costs compare to our competitors. Perhaps we could be more efficient and find a way to earn our normal return on X-12. Besides, my production people hate producing S-15. It's very difficult to produce.

After meeting with Rick, Diane requested an investigation of the production costs and comparative efficiency. Independent consultants were hired. After a three- month assessment, the consulting group provided the following information on the plant's production activities and costs associated with the two products:

	X-12	S-15
Production (kilograms)	1,000,000	200,000
Selling price	$15.93	$12.00
Overhead per unit*	$6.41	$2.89
Prime cost per kilogram	$4.27	$3.13
Number of production runs	100	200
Receiving orders	400	1,000
Machine hours	125,000	60,000
Direct labor hours	250,000	22,500
Engineering hours	5,000	5,000
Material handling (number of moves)	500	400

*Calculated using a plantwide rate based on direct labor hours, which is the current way of assigning the plant's overhead to its products.

The consulting group recommended switching the overhead assignment to an activity-based approach. It maintained that activity-based costing assignment is more accurate and will provide better information for decision making. To facilitate this recommendation, the plant's activities were grouped into homogeneous sets based on common consumption ratios. The costs of these pooled activities follow:

Overhead pool:*

Setup costs	$ 240,000
Machine costs	1,750,000
Receiving costs	2,100,000
Engineering costs	2,000,000
Material-handling  costs	900,000
Total	$6,990,000

*The pools are named for the major activities found within them. All overhead costs within each pool can be assigned using a single driver (based on the major activity after which the pool is named).

Required

1. Verify the overhead cost per unit reported by the consulting group using direct labor hours to assign overhead. Compute the per-unit gross margin for each product.

2. Recompute the unit cost of each product using activity-based costing. Compute the per-unit gross margin for each product.

3. Should the company switch its emphasis from the high-volume product to the low-volume product? Comment on the validity of the plant manager's concern that competitors are selling below the cost of producing compound X-12.

4. Explain the apparent lack of competition for S-15. Comment also on the will- ingness of customers to accept a 25 percent increase in price for this compound.

5. Describe what actions you would take based on the information provided by the activity-based unit costs.