Distortions Caused by Inappropriate Overhead Allocation Base: Steve Stanley, Inc. (SSI) manufactures creamy deluxe chocolate candy bars. The firm has developed three distinct products, Almond Dream, Krispy Krackle, and Creamy Crunch.

While SSI is profitable, Steve Stanley is quite concerned over the profitability of each product and the product-costing methods currently employed. In particular, Steve questions whether the overhead allocation base of direct labor-hours accurately reflects the costs incurred during the production process of each product.

In reviewing cost reports with the marketing manager, Steve notices that Creamy Crunch appears exceptionally profitable, while Almond Dream appears to be pro- duced at a loss. This surprises both Steve and the manager, and after much discussion, they are convinced the cost accounting system is at fault and that Almond Dream is performing very well at the current market price.

Steve Stanley decides to hire Jean Sharpe, a management consultant, to study the firm's cost system over the next month and present her findings and recommenda- tions to senior management. Her objective is to identify and demonstrate how the cost accounting system might be distorting the firm's product costs.

Jean Sharpe begins her study by gathering information and documenting the existing cost accounting system. The system is rather simplistic, using a single overhead allocation base, direct labor-hours, to calculate and apply overhead rates to all products. The rate is calculated by summing variable and fixed overhead costs and then dividing the result by the number of direct labor-hours. The product cost is determined by multiplying the number of direct labor-hours required to manufacture the product by the overhead rate and adding this amount to the direct labor and direct material costs.

SSI engages in two distinct production processes for each product. Process 1 is labor-intensive, using a high proportion of direct materials and labor. Process 2 uses special packing equipment which wraps each individual candy bar and then packs them into boxes of 24 bars. The boxes are then packaged into cases containing six boxes. The special packing equipment is used on all three products and has a monthly capacity of 3,000 boxes, each containing 144 candy bars.

To illustrate the source of the distortions to senior management, Sharpe collects the cost data for the three products-Almond Dream, Krispy Krackle, and Creamy Crunch (see Exhibit A).

SSI recently adopted a general policy of discontinuing all products whose gross profit margin [(gross margin/selling price) x 100] percentages were less than 10 percent. By comparing the selling prices to the firm's costs and then calculating the gross margin percentages, Sharpe could determine which products, under the current cost system, should be dropped. The current selling prices of Almond Dream, Krispy Krackle, and Creamy Crunch were $85, $55, and $35 per case, respectively.

Required:

a. Complete the following schedule (Exhibit A) under the current cost system and determine which product(s), if any, would be dropped.

b. What characteristic of the product that would be dropped makes it appear relatively unprofitable?

c. Calculate the gross profit margin percentage for the remaining products. Assume SSI can sell all products it manufactures and that it will use the excess capacity from dropping a product to produce more of the most profitable product. If SSI maintains its current rule about dropping products, which additional products, if any, would SS1 drop under the existing cost system? Overhead would remain $69,500 per month under all alternatives.

d. Recalculate the gross profit margin percentage for the remaining product(s) and ascertain whether any additional product(s) would be dropped.

e. Discuss the outcome and any recommendations you might make to management regarding the current cost system and decision policies.

Exhibit A (4-39) Almond Dream Krispy Krackle Product costs: Labor hours per unit Total units produced Material cost per unit Direct labor per unit Labor-hours per product 7 3 1,000 1,000 $ 8.00 $ 2.00 42.00 18.00 7,000 3,000 Total overhead = $69,500 Total labor-hours = 11,000 Direct labor costs per hour = $6.00 Allocation rate per labor-hour = (a) Costs of products: Material cost per unit Direct labor cost per unit Allocated overhead per unit (to be computed) Product cost Creamy Crunch 1 1,000 $ 9.00 6.00 1,000 $ 8.00 42.00 $ 2.00 18.00 $9.00 6.00 (b) (c) (d) (e) (f) (g)