EXERCISE 8-21 (CONTINUED)

4. Although the bi-relay accounts for only 20% of the company’s total pro-

duction, it is responsible for two-thirds of the part types carried in inven-

tory and 60% of the machine-hours worked. It is also responsible for

well over half of the tests needed for quality control. These factors have

been concealed as a result of using direct labor-hours as the base for

assigning overhead cost to products. Since the bi-relay is responsible for

a majority of the activity, under activity-based costing it is assigned a

larger amount of overhead cost.

Managers should be cautious about drawing firm conclusions about the

profitability of products from the above activity-based cost analysis. The

ABC system used in this company is not completely suitable for making

decisions. Product costs probably include costs of idle capacity and or-

ganization-sustaining costs. They also exclude nonmanufacturing costs

that may be caused by the products. Nevertheless, the above analysis is

suggestive. The bi-relay may not be as profitable as management be-

lieves, and this may be the reason for the company’s declining profits.

Note that from part (1), the unit product cost of the bi-relay is $85. In

part (3), however, the activity-based costing system sets the unit prod-

uct cost of the bi-relay at $116.80. This is a difference of $31.80 per

unit. If the $85 cost figure is being used as the base for determining a

selling price for the bi-relay, the company may be losing money on this

product.

Case 8-31 (90 minutes)