Finance

Executive Summary
The companys success depends on its ability to maintain a decent profit margin. This business case report about Destin Brass Products Co. discusses the present product costing and pricing concerns of the management. The company targets a 35 percent gross margin in all its three products valves, pumps and flow controllers. While it manages to meet the target for the valves and even exceed in the flow controllers, the price of pumps continues to slide because of the competitors reduced prices.  This report aimed to investigate probable explanation for the competitors pricing scheme by evaluating different overhead allocation methods.

Presently, the company employs the traditional overhead cost allocation system that distributes monthly overhead based on labor costs. Analysis of this approach shows that although it works for a company with a single product like what Destin Brass Products used to be, the companys present situation calls for an allocation approach that reflects the actual cost of producing and marketing its different products. Two other approaches discussed in the report are the machine-hour based approach and the activity-based costing method. The machine-hour based approach uses machine usage as basis for distributing overhead expenses to the different products. Although this is logical as machine usage better reflects resource consumption than direct labor, it fails to reflect the actual distribution of expenses.  The activities-based costing scheme on the other hand allocates the expenses based on the number of transactions. The analysis showed that flow controllers require significantly more transactions to process than the other products, thus its overhead allocation should be proportionate to its consumption. The report concludes that the activity-based costing method approximates the distribution of expenses in the production process better than the other methods. Thus, the report recommends the adoption of the said approach.

Introduction
This report has been prepared for Roland Guidry, president of Destin Brass Products. The report aimed to evaluate the companys present costing and pricing approach and come up with possible options to address the managements concerns about the decline in profit in their pumps due to the competitors reduced pricing. This includes a quantitative analysis of their present approach in allocating overhead expenses. Also, two proposed method for allocating overhead costs were also evaluated.

The report consists of five sections, which are outlined below.
Section 1. Introduction. This section outlines the purpose and scope of the report.
Section 2. Company Background. This section outlines a short history of the company and the different products they are offering.
Section 3. Issues Facing Managers. In this section, the present concerns of the management in Destin Brass Corporation are reviewed.
Section 4. Overhead Allocation Options. In this section, different overhead cost allocation approaches proposed by Alford, the controller were explored.
Section 5. Quantitative Assessment. This section tackles the present overhead allocation system of the company and compares it with other options the company can take to improve their present approach and give light to the managers dilemma regarding their costing and pricing method as well as the companys future.
Section 6. Summary and Recommendations. This section synthesizes the previous sections to determine which options are best for the company.

Company Background
Destin Brass Products Co. started from a moribund commercial machine shop in 1984 in Destin, Florida. It was started by Roland Guidry, Steve Abbott and John Scott. Abbott discovered the demand for high quality brass valves. Using Scotts experience in manufacturing high-quality brass boat fittings and Guidrys training from the United States Air Force, the three started the company. They brought in Peggy Alford, an accountant with experience in the manufacturing business to join the team.

Destin Brass Products valves were a hit. Although the precise engineering needed in manufacturing the product made its cost high, the company managed to supply its single customer and maintain their 35 percent target gross margin without any price adjustments. Presently, valves make up 24 percent of their revenue. Taking advantage of the potential of brass for other purposes, the company expanded into producing brass pumps and flow controllers. The high demand for pumps eventually made it their most marketable product, presently contributing 55 percent of the companys revenues. Despite the competition, Destin Brass Products was able to command a fair share of the market. Their third product, flow controllers constitutes 21 percent of the revenue. Based on the companys record, flow controllers make the highest profit, with almost 42 percent profit margin.

3. Issues Facing Managers
The issues facing the managers presently are centered on the pricing and costing of two of their two products pumps and flow controllers. The managers have set a gross margin of 35 percent for all their products. However, based on last months evaluation, the actual selling prices did not meet the target due to reduction in pump prices of their competitors. The management is worried that if the competitors reduced cost continues, the companys gross margin would slip. That scenario is not good for the company as a low margin could force them to drop out of the market.

Another concern perplexing the managers is that of flow controllers. The company realized that they seem not to have any competitor in the market. Though they had a 12 percent increase in prices, the demand remained strong. Alford suspects that their competitors are making different assumptions in distributing overhead prices. These concerns prompted the managers to explore other overhead cost allocation approaches which might explain the discrepancies between the companys costing and pricing schemes and that of their competitors.

Overhead Allocation Options
The companys monthly product and cost summary (Exhibit 2) reflects the direct and indirect costs and assumptions about product costing, pricing and production volume. Based on the summary, the companys costs are divided into three areas material, labor and overhead expenses.

Presently, the company employs the traditional cost accounting system (Exhibit 3). In the traditional system, material costs are based on the expenses incurred in buying each component of the product. This is computed per unit of product produced. Labor cost on the other hand is computed from the number of standard runs multiplied by the basic pay rate of 16 per hour. Allocation for labor is likewise done directly per unit of product. Overhead costs are charged each month as period expenses. As shown in Exhibit 3, the total overhead expenses was calculated and divided by the total labor hours to give the overhead rate. Overhead cost per unit is computed based on this rate.

However, using this approach seem to give the company different costing and pricing results than that employed by their competitors. Realizing the need for different approaches, two new overhead allocation schemes were proposed.

Alford proposed a revised method (Exhibit 4). In the revised method, overhead costs related to receiving and handling was allocated to each product line based on material costs. The same was done for the set up labor cost since both costs have no relationship to the total labor cost of a production run. Lastly, the absorption rate based on machine hours was determined. This revised overhead cost allocation reduced the pump costs by 4.00 making the companys profit margin 27 percent instead of 22 percent. The new method increased the cost of valves but reduced that of flow controllers. While this explains the competitors reduced cost of pumps, it does not explain the low competition in the flow controller production and the high gross profit margin.

A newer approach discussed during the meeting was the activity-based costing (ABC). This method focuses on the activity rather than volume in distributing overhead expenses. Based on this method, it is the activities like receiving and handling material, packing and shipping, and engineering that use capital, thus overhead costs should be allocated based on the number of these transactions. In this method, material, direct labor and set up labor are allocated in the same way as in the revised method. However, the other overhead expenses are allocated based on the activities performed for each product. Thus, a product that requires more handling and shipping transactions has to cover a bigger portion of the total cost incurred for those transactions.  Alford and Scott came up with the distribution of monthly activities undergone by the company (Exhibit 5).

A new costing computation was prepared based on the case analysis (Exhibit 7). As mentioned earlier, this method allocates overhead expenses based on the number of transactions and effort required by each product. A more detailed assessment of the approach is provided in the next section.

Quantitative Assessment
In this section, quantitative assessment of the three approaches presented in Section 5 will be provided. This approach simplifies overhead allocation by accounting for the total cost incurred and distributing it to the different products based on the cost of direct labor. From this approach, total monthly overhead expenses were calculated. Then overhead rate based on total expenses and total run labor was obtained. The overhead rate resulted to the standard price of 37.56 for valve, 63.12 for pump and 56.50 for flow controllers. To obtain the target margins of 35 for each product, target selling prices were set at 57.78 for valves, 97.10 for pumps and 86.96 for flow controllers. Based on last months record, although the valves were sold at the targeted price, the company had to reduce the pump costs to 81.26 per unit to compete with their competitors costs. Fortunately, increasing flow controllers cost by 12.5 did not affect the demand. The end of month profitability analysis showed that the profit margins for valves, pumps and flow controllers were, 35, 22 and 42 respectively.
As mentioned earlier, the figures for pumps prompted the managers to look for other methods of allocating overhead expenses. In the revised method proposed by Alford (Exhibit 4), overhead was allocated on two levels. The first level or material-related expenses was allocated based on the cost of material used for each product.  In the second level, overhead was distributed based on the cost of machine hour.  The first approach accounts for the fact that the material-related expenses are not related to the production expenses, thus they are calculated based on material costs. Since the remaining expenses were all production related, machine-hours was used as the basis for cost allocation. According to Alford, this cost distribution scheme is better as machine usage is more expensive than the labor costs. Based on this approach, the standard outlay of each product was  49.00,  58.95 and  47.96 for valves, pumps and flow controllers, respectively. Using last months selling prices the profit margins obtained for each product were 15 for valves, 27 for pumps and 51 for flow controllers. This approach significantly increased the gross profit margin for pumps which might explain the costing of the competitors however, it makes that of the valves significantly lower and flow controllers even higher than their seemingly bloated costing. This clearly requires further inquiry on what really affects overhead costs.

In the proposed activity-based costing, overhead expenses were distributed based on the number of transactions or activities incurred per product. This approach is logical since it is the transactions that incur expenses. Based on the activity analysis prepared by Scott and Alford, a new costing was prepared (Exhibit 7). Like in the revised method, the material and labor expenses were directly allocated for each product. In terms of overhead expenses, the cost for each product was determined based on the proportionate number of transactions incurred. For example, the total cost of receiving component is 20,000 per month. Since valves only require 4 transactions or 3 of the total number of transactions, only 3 of the cost was allocated to it or 600.00. This means that to produce 7500 units of valves per month, the company spends 600.00 on receiving the components. The pumps require 25 transactions or 19 of the total which makes the expense equal to 3800.00, while the flow controllers require 100 transactions, making up 78 of the total activities. This results to allocation of 78 the cost or 15,600. What is remarkable in using this approach is that it reflects which activities consume the bulk of the expenses. Since the flow controllers incur 78 of the material handling and receiving transactions, it was proportionately allocated 78 of the monthly expense for material handling and receiving. The same approach was done for each of the overhead expenses. Based on the activity analysis (Exhibit 5), the valves, pumps and flow controllers require 1, 7 and 22 packing and shipping transactions respectively, thus the cost distribution was based on these proportions. The total costs for each product based on this method are 37.71 for valves, 48.79 for pumps and 100.76 for flow controllers.

Using last months selling prices, the profitability analysis (Exhibit 8) shows that the actual gross margin for valves is 35 which is right on target. In the case of pumps, the actual gross margin using the activity-based costing approach is 40. Surprisingly, flow controllers which seemed the most profitable based on the other two approaches yielded a negative gross margin (-4) using this approach. This could be explained by the significantly higher number of transactions needed to manufacture and distribute flow controllers compared with the other two products. This approach explains why the competitors reduce the price of pumps and the lack of competitors in flow controller production. It is evident from the ABC method that manufacturing flow controllers costs more than what Destin Brass had been charging their clients and competitors did not want to compete with their pricing.

What the Destin Brass Products managers failed to consider in their present overhead allocation scheme is that different products require different receiving, handling, engineering, packing and shipping transactions, thus different expenses. Although the traditional approach was applicable during the companys earlier years, when they were still producing single products (valves), the integration of other products in their manufacturing process require more complicated overhead distribution scheme. Without realizing it, they had been apportioning some of the cost of producing flow controllers to that of pumps, thereby increasing the cost of pumps and reducing that of flow controllers. This caused the low profit margin for pumps and high profit margin for flow controllers.

Summary and Recommendations
This analysis shows that the kind of overhead allocation scheme employed has significant implication in the costing of products. While the traditional approach may work for companies engaged in only one kind of product like what Destin Brass Products used to be, it does not work in their present situation. Each product requires different production and distribution method and prices should be properly allocated in order to better reflect the actual expenses incurred for each product.

Based on the result of the analysis, this report recommends the adoption of the acivity-based costing method. This will better reflect the expenses incurred in the production and distribution of the different products. Through this approach, management will have a better idea of which products are contributing to most expenses and which products require the least financial resources.