Destin Brass Products has a predicament in that it currently is being forced to sell its pumps at a lower profit margin in order to stay competitive in the pump sales market. Pump sales are important to the company's success because they sell more pumps (12,500) than their two other products, and consequently pump sales are the primary driver for Destin's revenues.
We suggest Destin Brass Products implement two recommendations to solve its current predicament. First, Destin should implement an activity-based cost (ABC) accounting system. Second, Destin should raise the price for its flow controllers so that they do not incur a loss on every flow controller sold.
The central question of the Destin case centers on the cost of pums. As Manufacturing Manager John Scott states, "It really is amazing to me that our competitors keep reducing prices on pumps. Even though our manufacturing process is better than theirs, I truly do not believe we are less efficient or cost effective." Consequently, Destin must cut its prices to stay competitive. By doing this they remain competitive but reduce their profit margin from the targeted 35% to only 22%.
The key difference between the three costing systems is how overhead costs are allocated. Under the traditional cost accounting method, overhead costs are applied to each product at a uniform rate. The more modern or "revised" cost accounting system (Exhibit 4 of the Destin case notes) separates material related overhead from the balance of manufacturing overhead costs. This method provides a little more detail than the traditional method, but still results in some distortion of true product costs.
So why should Destin use the ABC method ? The most important reason for using ABC accounting is that it provides the most accurate cost information for each product. By focusing on the number of transactions in each of five different categories (receiving, material handling, packing and shipping, engineering and maintenance), Destin can more accurately allocate overhead costs to each product.
To illustrate, activity analysis of the overhead generating departments shows that flow controllers consistently require many more transactions than valves and pumps. For example, in receiving and handling flow controllers require 78% of the transactions while valves and pumps only require 3% and 19%, respectively. Further, 50% of engineering overhead-related costs are attributed to flow controllers while only 20% and 30% for valves and pumps, respectively.
Clearly with such disproportion of overhead costs among the three products, it simply does not make sense to uniformly allocate overhead costs. This lends credence to Mr. Scott's assumption on Destin's efficiency. That is, Destin's competitors are probably not more cost-effective or efficient. Rather, the cost accounting system Destin is using inaccurately inflates the pump production costs.
Two Exhibits are attached, which support our conclusions. Exhibit A illustrates how product costs using the ABC method were derived. Exhibit B summarizes the gross profit margin percentages and total profits shown using each of the three cost accounting systems. As one can see, the product market the company puts its emphasis on will depend upon which cost accounting system they use. For example, if Destin were to have the more modern or "revised" costing system in place, it would appear that they would want to place heavy emphasis on the flow controller market. With a gross profit margin percentage of nearly 51%, Destin would want to boost production of flow controllers.
Using ABC, however, one can see that boosting production of flow controllers would be a mistake. ABC shows that each flow controller produced creates a loss of 3.51% of the selling price. This example shows that the cost accounting system used can show very different results.
In terms of this particular case, Exhibit B illustrates that using ABC will show the highest profit ($541,635) despite the loss realized with the production of flow controllers.
If Destin is incurring a loss for every flow controller produced, shouldn't Destin simply abandon production of flow controllers ? The answer is not so simple. Many of the costs associated with running this production facility are fixed costs. Therefore, these are costs the company will have to endure whether they produce or not. It is our conclusion that the variable cost of producing flow controllers is still lower than the price at which flow controllers are sold. Therefore, production of the flow controller product line should not be abandoned.
To further boost profits, however, we recommend raising the selling price of flow controllers at least to the break-even cost ($100.48), as determined using the ABC method. It is our contention that the company can even do this without having a significant effect on demand while also raising profit by $13K. As stated in the case, "Destin had almost no competition in the flow controller market. He (Steve Abbot) had recently raised flow controller prices to 12.5% with no apparent effect on demand." This is a further example which shows that Destin is still not pricing its flow controllers high enough. Simple rules of supply and demand show that if the flow controller price were at equilibrium or above, a raise in the price would result in a lowering of demand.
In conclusion, when Destin had to cut prices on its pumps to stay competitive with the rest of the industry, it was perceived that they were earning a lower profit margin and that competitors were more efficient or cost effective. The reality, however, is that Destin set its pump prices too high because they were not using the most accurate cost accounting system, which inflated the calculated cost of pumps. By adopting ABC, Destin can determine its costs more accurately and more consistently with the rest of the industry. Further, ABC shows that producing flow controllers is actually more costly than they had originally calculated with the traditional cost accounting method. With virtually no competitors in the flow controller market, Destin should be able to raise its prices on flow controllers without having a significant impact on demand and thus boost profits.
