Determine Contribution Margin And Cost Allocation Impact

Determine Contribution Margin and Cost Allocation Impact for Premier Products

Premier Products Inc. manufactures tennis rackets and has experienced significant growth. Concerns have arisen regarding the accuracy of product costing methods, which impact profitability analysis and product discontinuation decisions. The company currently employs a simplistic costing system that allocates overhead based solely on labor hours, potentially skewing profit assessments. This paper examines the contribution margins of each product when only variable costs are allocated, assesses which products maximize overall contribution margin, evaluates the accuracy of the current costing method, considers effects of discontinuing certain products, and explores implications of modifying the costing approach to improve accuracy of variable and fixed costs.

Paper For Above instruction

Premier Products Inc.'s current cost system allocates all overhead costs based exclusively on direct labor hours, a method that assumes proportionality between labor hours and overhead expenses. While straightforward, this approach can distort product profitability, especially when products have differing resource consumption patterns or capacities.

Contribution Margin Analysis with Variable Costs

The contribution margin (CM) per unit is defined as the selling price minus variable costs. For Premier's products, the variable costs include direct material, direct labor, and variable overhead. Using data from the provided tables, the variable costs per unit are as follows:

• Product A: Material $15.00 + Labor $30.00 + Variable Overhead $15.00 = $60.00
• Product B: Material $5.00 + Labor $5.00 + Variable Overhead $7.50 = $17.50
• Product C: Material $10.00 + Labor $10.00 + Variable Overhead $10.00 = $30.00
• Product D: Material $5.00 + Labor $5.00 + Variable Overhead $7.50 = $22.50

The selling prices are:

• Product A: $98.00
• Product B: $38.50
• Product C: $59.50
• Product D: $49.00

Therefore, the contribution margins per unit are:

• Product A: $98.00 - $60.00 = $38.00
• Product B: $38.50 - $17.50 = $21.00
• Product C: $59.50 - $30.00 = $29.50
• Product D: $49.00 - $22.50 = $26.50

These results indicate that product A yields the highest contribution margin, suggesting it would be the most profitable per unit, followed by product C, D, and B. When seeking to maximize contribution margins across the product line, the company should prioritize producing products with higher CM per unit, notably product A, and consider eliminating or reducing production of lower-margin items like B, unless strategic factors warrant their continued manufacture.

Implications of Simplistic Cost Allocation

The current overhead allocation method, based solely on direct labor hours, is potentially inaccurate, particularly because products A and B share similar manufacturing processes and capacities distinct from those of C and D. This approach assumes a linear relationship between labor hours and overhead costs, which may not reflect reality, especially given diverse resource consumption patterns. For example, products with high fixed or batch-related overhead costs may be undercosted when allocated purely on labor hours, leading to overestimation of profitability and faulty decision-making, including unwarranted product discontinuation.

Harrison's concern that products might be unfairly judged is valid; the inaccurate overhead allocation may distort true product costs, causing the company to drop profitable products or retain unprofitable ones. An alternative, more refined costing method, such as Activity-Based Costing (ABC), could better assign overhead costs based on actual resource consumption, yielding more precise product cost information.

Impact of Discontinuing Products on Demand and Overall Profitability

Discontinuing products with artificially low contribution margins based on flawed cost data could inadvertently affect the demand for remaining products. For instance, removing low-margin products might elevate the perceived value of remaining offerings, potentially increasing overall demand if customers view the product line as more exclusive or higher quality. Conversely, it might also result in a loss of sales volume if customers are attracted to the full product range. Such adjustments could influence revenues and profitability, emphasizing the importance of accurate costing to inform strategic decisions.

Cost Modification: Tracing All Variable Costs

If the firm's costing system is modified to trace all variable costs directly to each product, the cost accuracy would improve significantly. This entails assigning direct material, direct labor, and variable overhead precisely to each product based on their consumption, rather than allocating a proportionate share based on labor hours.

Applying this approach, the costs per unit would remain the same as the initially identified variable costs, without embedded overhead allocations based solely on labor hours. Fixed costs, which are not directly traceable, would continue to be allocated using existing methods.

Analyzing the impact on profitability, this system would reveal a more accurate contribution margin for each product, potentially changing their relative profitability. For example, product B's contribution margin could increase or decrease if previously under- or over-allocated overhead is corrected. Overall, this approach enhances decision-making by providing a clearer picture of each product's true contribution to fixed costs and profits.

Evaluating Costing System Effectiveness and Challenges

The current costing system, with its oversimplified overhead allocation, introduces inaccuracies that could mislead strategic choices, including product discontinuation or resource allocation. Its main drawbacks include misrepresentation of product profitability and potential misidentification of cost drivers. Transitioning to a more detailed costing system, such as ABC, could mitigate these issues by allocating overhead more precisely, thereby improving profitability analysis.

However, implementing such systems involves substantial effort, increased data collection, and complexity. Moreover, the accuracy gains must be weighed against these costs. The firm must assess whether the improved decision-making justifies the investment in a sophisticated costing approach.

Conclusion

In conclusion, Premier Products' reliance on a simplified overhead allocation based on direct labor hours compromises the accuracy of profitability analysis and strategic decision-making. Calculating contribution margins based on variable costs highlights that product A is most profitable per unit, suggesting prioritization for production. To enhance accuracy, the company should consider adopting a more detailed costing method, such as ABC, which would more reliably assign overhead costs and inform better managerial decisions. Ultimately, establishing a robust costing system aligns with the company's growth trajectory and strategic objectives, ensuring profitability is accurately assessed and resources are optimally allocated.

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