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Ontario Pump Company (Memo to Mario Carlo)

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MANAGERIAL ACCOUNTING
SUBJECT:
Using Accounting Information In Decision Making

Please solve the problem in the form of memo.

Below are the details with the problem statement

-----------------------------
Ontario Pump Company, a small manufacturing company in Toronto, manufactures 3 types of pumps used in a variety of applications. For many years the company has been profitable and has operated at capacity. However, in the last two years prices on all pumps were reduced and selling expenses increased to meet competition and keep the plant operating at capacity. Second-quarter results for the current year, which follow, typify recent experience.

ONTARIO PUMP COMPANY
Income Statement
2nd quarter
(in thousands)

R-Pump F-Pump S-Pump Total

Sales $4,800 $2,700 $2,700 $10,200
COGS 3,144 2,310 2,850 8,304
Gross Margin $ 1,656 $390 $ (150) $1,896
Selling & Administrative expenses 1,110 555 405 2,070
Income before the taxes $546 $(165) $(555) $(174)

Maria Carlo, the company's president, is concerned about the results of the pricing, selling, and production prices. After reviewing the second-quarter results she asked her management staff to consider the following 3 suggestions:

1) Discontinue the S-Pump line immediately. S-Pump would not be returned to the product line unless the problems with the pump can be identified and resolved.
2) Increase quarterly sales promotion by $300,000 on the R-Pump product line in order to increase sales volume by 15%.
3) Cut production on the F-Pump line by 50%, and cut the traceable advertising and promotion for this line to $60,000 each quarter.

Justin Sperry, the controller, suggested a more careful study of the financial relationships to determine the possible effects on the company's operating results of the president's proposed course of action. The president agreed and assigned JoAnn Brower, the assistant controller, to prepare an analysis. Brower has gathered the following information:

- The unit sales prices for the 3 pumps are as follows:
R-Pump $600
F-Pump $270
S-Pump $540

- The company is manufacturing at capacity and is selling all the pumps it produces.

- All 3 pumps are manufactured with common equipment and facilities.

-The selling and administrative expense is allowed to the 3 pump lines based on average sales volume over the past 3 years.

- Special selling expenses (primarily advertising, promotion, and shipping) are incurred for each pump as follows:
Quarterly Advertising & Promotion Shipping Expenses
R-Pump $630,000 $30 per unit
F-Pump $300,000 12 per unit
S-Pump $120,000 30 per unit

- The unit manufacturing costs for the 3 pumps are as follows:
R-Pump F-Pump S-Pump
DM $93 $51 $150
DL 120 60 180
Variable Manufacturing OH 135 90 180
Fixed Manufacturing OH 45 30 60
Total $393 $231 $570

REQUIRED:
1) JoAnn Brower says that Ontario Pump Company's product-line income statement for the 2nd quarter is not suitable for analyzing proposals and making decisions such as the ones suggested by Maria carlo. Write a memo to Ontario Pump's president that addresses the following points:
a) Explain why the product-line income statement as presented is not suitable for analysis and decision making.
b) Describe an alternative income-statement format that would be more suitable for analysis and decision making, and explain why it is better.

2) Use the operating data presented for Ontario Pump Company and assume that the president's proposed course of action had been implemented at the beginning of the second quarter. Then evaluate the president's proposal by specifically responding to the following points:
a) Are each of the 3 suggestions cost-effective? Support your discussion with an analysis that shows that net impact on income before taxes for each of the 3 suggestions.
b) Was the president correct in proposing that the S-Pump line be eliminated? Explain your answer.
c) Was the president correct in promoting the R-Pump line rather than the F-Pump line? Explain your answer.
d) Does the proposed course of action make effective use of the company's capacity?
Explain your answer.

3) Are there any qualitative factors that Ontario Pump Company's management should consider before it drops the S-Pump line? Explain your answer.
CHECK KEY: C14-62
2. a. Unit contribution margin, F-Pump: $57
2.c. Contribution per direct-labor dollar, R-Pump: 1.85

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Solution Preview

Memo:
From: To:
JoAnn Brower Maria Carlo, the company's president

The product line income statement as presented in not suitable for analysis and decision making because it does not capture the actual allocation of cost to each unit.
The alternative to the income statement format would be activities based costing.
There is a solution to the problem and it is as simple as Activity Based Costing.
Activity Based Costing, or simply ABC as it is known in the business world, if correctly applied and utilized can rank your products in terms of profitability.

Activity based costing is a costing method that provides managers with useful information they need regarding the contribution that each product makes to overall profitability. Also, ABC allows managers to see how to maximize performance and implement sound profit-growth strategies.
ABC also makes it very clear that integrated costs associated with the services that the product demands play a crucial role in determining each product's contribution to net profit.

Studies have shown that 20% of all products virtually provide all the profits of a company. Another 60% break even and the remaining 20% only reduce the bottom line. Wouldn't it be nice if you had the names of that 20% of headache-inducing products that are literally more trouble than they're worth?

To determine how much a product is costing you, you must first identify the activities that relate to each product and determine the total cost absorbed by those activities. These activities or "cost drivers" should be considered then to measure the level of activity absorbed by each product. The ultimate purpose of implementing ABC is to separate these activities into individual cost drivers. Then, all you have to do is measure each product's participation in the specific cost.
When choosing cost drivers, make sure they are relevant and easy to measure. Relevancy relates to the direct or indirect relationship it bears to the cost of doing business and ease of measurement means that you must be able to allocate to each product the portion attributable to the activities consumed.
Cost drivers might include, but not be limited to, inside/outside sales, order processing, credit, delivery, telephone expenses, training, application ...

Solution Summary

Here is just a sample of what you'll find in this solution:

"The increase in ad expenses is justified till the marginal revenue from ads is greater than the marginal cost of ads. Once the point is reached where the marginal cost of ads is equal to the marginal revenue, the company must stop increasing its ad expenditure."

$2.19