Product Cost

Midway Manufacturing, Inc. manufactures two models of valves: a regular model and a deluxe model. The deluxe model, introduced two years ago, has been very successful. It now accounts for more than half of the firm's profits, as evidenced by the following income statement for last year:

Total Regular Deluxe
Sales $2,400,000 $1,200,000 $1,200,000
Cost of goods sold 1,540,000 780,000 760,000
Gross margin $ 860,000 $ 420,000 $ 440,000
Selling/administrative expenses 500,000 250,000 250,000
Operating income $ 360,000 $ 170,000 $ 190,000
Number of units 500,000 300,000 200,000

Midway's manufacturing plant in Central Texas has two production departments: machining and assembling. The total cost of goods sold last year included $720,000 of manufacturing overhead (production support) costs: $504,000 incurred in the plant's machining department and $216,000 in its assembling department. Overhead was applied to valves using a plantwide rate based on direct labor hours. The following hours were recorded last year for the two products:

Direct Labor Hours
Product Machining Department Assembling Department Totals
Regular 15,000 DLH 3,000 DLH 18,000 DLH
Deluxe 13,000 DLH 5,000 DLH 18,000 DLH
Total DLH 28,000 DLH 8,000 DLH 36,000 DLH

Midway's direct labor wage rate is $10.00 per hour. Direct materials cost is $0.80 per unit for the regular model and $1.10 per unit for the deluxe model. An average customer order for the regular model is for 5,000 valves, whereas each order for the deluxe model is for 2,000 valves. The production machines require one setup for each order. Three hours are required per machine setup for the regular model; the more-complex deluxe model requires 5 hours per setup.
Selling and administrative expenses have been allocated to the two models in proportion to their sales revenue.
Midway Manufacturing's profitability has declined over the past two years despite the successful introduction of the deluxe model, which now has captured 65% of its segment of the industry. Market share for the regular model has decreased to 12%. In an attempt to understand the reasons for its declining profitability, the company has appointed a special task force.
The task force is considering a new accounting system based on activity analysis. This system employs four cost drivers: machining department DLH (direct labor hours), assembling department DLH, setup hours, and number of orders. Production support costs are traced to four cost pools, each identified with a unique driver, as shown in the following table:

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Number of Cost Driver Units
Activity Cost Driver Costs Total Regular Deluxe
Machining DLH $112,000 28,000 15,000 13,000
Assembling DLH 96,000 8,000 3,000 5,000
Setup hours 272,000 680 180 500
Number of orders 240,000 160 60 100
Total production support costs $720,000

The task force also analyzed selling and administrative expenses. These costs include a 5% sales commission on regular models and a 10% commission on deluxe models. Advertising and promotion expenses were found to be $50,000 for the regular model and $90,000 for the deluxe model. The remaining $180,000 of selling and administrative expenses are attributed equally to the two products.

Required:

1. For each valve model, compute the product costs per unit and the operating income per unit using the existing accounting system. Show all the components of product cost: direct materials, direct labor, and manufacturing overhead.
2. Again for each model, determine the per-unit product costs and operating income using the new activity-based costing system. Show all the intermediate steps, including the cost driver rates and components of product costs.
3. Explain why the existing accounting system at Midway Manufacturing is distorting its product costs and profitability. Support your answer with numbers when necessary.
4. Analyze the profitability of the two products. What insight does the ABC profitability analysis provide? What changes should Midway consider in order to improve its profitability?