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Question: the manufacturer health care services has historically used an indirect...

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The manufacturer, Health Care Services, has historically used an indirect cost allocation system based upon direct hours to manufacture for all its other product lines. The same was applied when PS6 was priced. However, Arnie, the person who performed the indirect cost analysis and set the sales price, is no longer at the company, and the detailed analysis is no longer available. Through e-mail and telephone conversations, Arnie said the current price was set at about 10% above the total manufacturing cost determined 2 years ago, and that some records were available in the design department files. A search of these files revealed the manufacturing and cost information in Table 15–11 below (or view the table as an image). It is clear from these and other records that Arnie used traditional indirect cost analysis based on direct labor hours to estimate the total manufacturing costs of $9.73 per unit for the standard model and $27.07 per unit for the premium model.

Table 15-11 Historical Records of Direct and Indirect Cost Analyses for PS6

PS6 Direct Cost (DC) Evaluation

Model

Direct Labor,
$∕Unit1 (Links to an external site.)Links to an external site.

Direct Material,
$∕Unit

Direct Labor,
Hours∕Unit

Total Direct
Labor Hours

Standard

5.00

2.50

0.25

187,500

Premium

10.00

3.75

0.50

125,000

PS6 Indirect Cost (IDC) Evaluation

Model

Direct Labor,
Hours∕Unit

Fraction IDC
Allocated

Allocated
IDC, $

Sales,
Units∕Year

Standard

0.25

1/3

1.67 million

750,000

Premium

0.50

2/3

3.33 million

250,000

1Average direct labor rate is $20 per hour.

Last year management decided to place the entire plant on the ABC system of indirect cost allocation. The costs and sales figures collected for the PS6 line the year before were still accurate. Five activities and their cost drivers were identified for the Health Care Services manufacturing operations (Table 15–12 below). Also, the volumes for each model are summarized in this table. (or view the table as an image.)

TABLE 15–12 PS6 Activities, Cost Drivers, and Volume Levels for ABC-Based Indirect Cost Allocation

Activity

Cost Driver

Volume/Year

Actual Cost,
$/Year

Quality

Inspections

20,000 inspections

800,000

Purchasing

Purchase orders

40,000 orders

1,200,000

Scheduling

Change orders

1,000 orders

800,000

Production setup

Setups

5,000 setups

1,000,000

Machine operations

Machine hours

10,000 hours

1,200,000

Volume Level for the Year

Cost Driver

Standard

Premium

Quality inspections

8,000

12,000

Purchase orders

30,000

10,000

Number of change orders

400

600

Production setup

1,500

3,500

Machine hours

7,000

3,000

The ABC method will be used henceforth, with the intention of determining the total cost and price based on its results. The first impression of the production manager is that the new system will show that indirect costs for PS6 are about the same as they have been for other products over the last several years when a standard model and an upgrade (premium) model were sold. Predictably, they state, the standard model will receive about 1∕3 of the indirect cost, and the premium will receive the remaining 2∕3. Fundamentally, there are two reasons why the production manager does not like to produce premium versions: They are less profitable for the company, and they require significantly more time and operations to manufacture.

Case Study Exercises

  1. Use traditional indirect cost allocation to verify Arnie’s cost and price estimates.
  2. Use the ABC method to estimate the indirect cost allocation and total cost for each model.
  3. If the prices and number of units sold are the same next year (750,000 standard and 250,000 premium), and all other costs remain constant, compare the profit from PS6 under the ABC method with the profit using the traditional indirect cost allocation method.
  4. What prices should Health Care Services charge next year based on the ABC method and a 10% markup over cost? What is the total profit from PS6 predicted to be if sales hold steady?
  5. Using the results above, comment on the production manager’s prediction of indirect costs using ABC (1∕3 standard; 2∕3 premium) and the two reasons given to not produce the premium version of PS6.
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