Cost Accounting Case for Premier Products

Premier Products

The contribution margin is the revenue less the variable costs. We know the price for each product, and we know the variable material costs. Labor costs are also know ($5/hr). Thus, the remaining issue is the allocation of overhead, which the company does on the basis of direct labor hours.

Contribution Margin

Product

Price

Materials

Labor

Overhead

Contribution

Cont. Margin

There are two production constraints. One machine can only be used for A or B, the other machine for only C and D. To maximize contribution margin, the company should produce the product with the highest contribution margin, which in this case is product B and product D. They have the highest contribution, and contribution margin.

To determine the impact on profits, the current profitability should be compared with the profitability that would arise from the proposed change. A pro forma income statement will illustrate, but of course the actual sales are not provided. We don't know how profitable the company is right now -- not sure the company would conduct this exercise without having its income statement available. But if it is assumed that the company can sell everything it makes, that is a starting point. What we learn is that this approach, of only looking at the contribution margin, results in the company losing money.

All an All B

All C

All D

Revenue

196000

77000

119000

98000

Variable Costs

90000

20000

50000

30000

Contribution

106000

57000

69000

68000

Fixed Costs

80000

80000

80000

80000

EBITDA

26000

-23000

-11000

-12000

The reason is that the only product that, when maximized, actually covers the overhead of Product A. This is because Product A is priced much high, so that in dollar value terms, 2000 units of Product A is more valuable than 2000 units of any other product. A and B are produced on one machine, and B is a much cheaper product.

This points to an issue with the allocation. Allocating by labor hours distorts the financials of each product. How it works is this. Product A takes six labor hours, and Product B takes one. Overhead is allocated this way, such that A takes on a lot of overhead allocation while B takes on very little. The problem is that the machine that produces them can only product 2000 units total, and the trade-off between producing one unit of A or one unit of B is even. The overhead allocation is therefore misaligned with actual production constraints because the opportunity cost of producing one unit of A is one unit of B, but the current allocation system prices it like the opportunity cost is 6 units of B. That makes the contribution calculation look like B is a much more viable product. The reality is that A is the more viable product of the two. The current methodology sticks A with so much overhead that it looks like the least profitable product. Take away that overhead and A is worth $53 per unit, B is worth $28.5 per unit. You can only make 2000 units of these combined, obviously 2000 units of A delivers more profit to the company.