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Using ABC to Improve Product Pricing and Gross Profit Margin

[Data attached.]

Drilling Innovations, Inc., produces specialized cutting heads used by companies that drill for oil and natural gas. 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 (machine hours). The ABC system uses a variety of cost drivers related to the activities used to produce the cutting heads. The three products involved in the trial run of the ABC system were GS-157, HS-241, and OS-367. The following data relate to these products; unit data have been rounded to the nearest penny.

1)
a. Determine the gross profit margin for each product produced based on the ABC data [(Selling price 2 ABC cost per unit) 3 Units produced].
b. Determine the gross profit margin for each product produced based on the traditional costing data [(Selling price 2 Traditional cost per unit) 3 Units produced].
c. Provide an explanation as to why the cost of OS-367 may have increased under the ABC system while the cost of GS-157 decreased.
d. Suggest what action management might take with respect to the discoveries resulting from the ABC versus traditional costing analysis. Assume that Drilling Innovations expects to produce a gross profit margin on each product of at least 30 percent of the selling price.

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

3) 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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Solution Preview

There were a few typos in the table provided:

Product Sales price Units OH Trad Per Unit, Trad OH ABC Per unit, ABC
GS-157 $19.30 120,000 $1,600,000 $13.33 $1,500,000 $12.50
HS-241 $17.50 90,000 $1,100,000 $12.22 $1,050,000 $11.67
OS-367 $15.10 40,000 $400,000 $10.00 $550,000 $13.75

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See excel attached for computations.

c. Provide an explanation as to why the cost of OS-367 may have increased under the ABC
system while the cost of GS-157 decreased.

ABC assigns overhead based on the consumption of overhead resources, not the ratio of use of one particular overhead activity. Under the traditional method, overhead was assigned based on machine hour use and ignored use of other overhead activities that incur costs. For example, OH-367 might be the only product that uses the outdoor drying area. But the costs of that drying area would be part of overall over and spread to all products ...

Solution Summary

Your tutorial is 431 words plus exhibits in Excel (click in cells to see computations) to give you an idea of why cost per unit has shifted and how management might respond to this data. Six circumstances where ABC is preferred are given.

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