Refer to the text discussion of Lopez Plastics Company on pages 136 – 140. Assume that the company has the traditional cost accounting system described in Exhibit 4-6 The top management team wants to reverse the pattern of quarterly losses. The company president, Angie Oaks, has emphasized the importance of profit improvement by linking future pay raises of the two product-line managers to their respective gross profit margins. She is concerned about the profitability of the pen casing product line, while pleased with the profitability of the cell phone casing line. She also believes that the unallocated costs of the company are too high compared to competitors. The office of controller, whose costs are included in the unallocated costs, is responsible for vendor relations and purchasing of direct materials. The controller and head of the engineering department proposed 1) a price reduction, and 2) use of more standard parts:

We should use more standard parts in cell phone casings, which will dramatically reduce the purchasing department’s work required for purchasing. I believe this should cut our office’s costs by as much as $20,000 per quarter. Product engineering agrees that this idea is not only feasible but, if implemented, would substantially reduce the design work required for cell phone casings. Quality would also improve.

Action

Reduce prices of cell phone casings 25%.

Use standard parts wherever possible in cell phone casings.

Predicted effects of action

The vice president of sales estimates that the improved quality of cell phone casings combined with the price reduction will yield a 100% increase in demand for cell phone casings per quarter.

The use of fewer suppliers will reduce vendor-relations work by the purchasing department. This will result in unallocated costs decreasing by $20,000.

One of the two engineers can be let go at an annual cost savings of $80,000, which is $20,000 quarterly.

Less of the plant and machinery will be used by production support so the allocation percentages will change from 75% and 25% to 80% and 20%. Much less engineer and CAD equipment costs will be needed for production support so these percentages will change from 80% and 20% to 50% and 50%.

Processing time, measured in direct-labor hours, will increase by 500 hours due to an expected 100% increase in sales and production of cell phone casings, but there is adequate capacity of labor and machine time. Direct-labor costs are fixed as are all of the indirect production costs.

Quality of cell phone casings will improve due to reduced complexity of processing.

1. Evaluate this idea using the traditional cost allocation system shown in Exhibit 4-6 on page 138. What would be the predicted profitability for each product line and the company as a whole? What would be the most likely level of support for the controller’s idea by the product managers of the pen casing product line and the cell phone casing product line? What would be the level of support by the president?

2. Assume that you have the ABC system described in Exhibit 4-7 on page 139 with the gross margin percentages as shown in the table in the solution to the first Summary Problem for Your Review on page 140 . Often, managers with ABC systems can anticipate more effects of improvement ideas because of their increased understanding of the operating system. In this case, although the total number of parts used would not change, the idea would reduce the number of distinct parts for cell phone casings from 20 to 11. Evaluate the controller’s idea using the ABC system described in Exhibit 4-7. What would be the predicted profitability for each product line and the company as a whole? What would be the most likely level of support for the controller’s idea by the product managers of the pen casing product line and the cell phone casing product line? What would be the level of support by the president?

3. As vice president, you have expressed concern about the traditional cost-allocation system’s product-cost accuracy and its ability to provide relevant information for operational control. Does the new ABC system satisfy your concerns? Explain.