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Product Pricing and Gross Profit Margin

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Pressure Products, Inc., produces specialized industrial hoses for applications such as high-pressure hydraulics and the transference of highly corrosive materials. The company has recently implemented an ABC system for three of its products, and is interested in evaluating its effectiveness before converting to an ABC system for all products. To perform this evaluation the company compiled data for the three products using both the traditional system and the new ABC system. The traditional system used a single driver (direct material costs). The ABC system uses a variety of cost drivers related to the activities used to produce the hoses. The three products involved in the trial run of the ABC system were R-150, S-127, and M-63. The following data relate to these products, and unit data have been rounded to the nearest penny.

Questions:
a) Explain why the cost of M-63 product increased under the ABC system while the cost of R-150 decreased.

b) Assume that Pressure Products expects to produce a gross profit margin on each product of at least 40% of the selling price. Suggest what action management might take with respect to the discoveries resulting from the ABC versus traditional costing analysis.

c) Describe the production characteristics (for example, high-volume, specialty, etc.) of the three products manufactured by Pressure Products, Inc. in our case study.

d) Describe the characteristics of products which would suggest it would be better to use ABC as an indirect cost allocation method over a traditional method such as direct labor hours.

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a) Explain why the cost of M-63 product increased under the ABC system while the cost of R-150 decreased.

Under ABC, products are allocated overhead based on their consumption/use of a number of activities (see example below), not just direct material costs. So, M-63 was likely a heavy user of something other than direct material (batches/machines) and so was allocated more when those other activities caused allocations. R-150 was likely a heavy user of direct materials and lighter user of other overhead activities and so when the overhead was split into activity pools, they received the same proportion of material related overhead but that pool was smaller. Imagine something like this:

......................................Traditional ...

$2.19