Destin Brass Case Study

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Comparing Product Costing Methods

Destin Brass manufactures three products; valves, pumps and flow controllers. Destin is challenged with determining how best to allocate the overhead costs to each product due to varying levels of costs accrued by each product line. Overhead costs can include, but is not limited to, indirect costs such as material and handling, engineering, utilities, training, safety, machine depreciation and maintenance. If Destin Brass only produced one product type, the unit costs would simply be the sum of all costs divided by the number of units produced. However, Destin does produce multiple products that accrue a varying amount of indirect costs depending on the type of product.

The current costing method used by Destin Brass Products is known as the traditional method for allocating all indirect costs. This method involves estimating all overhead costs into a cost pool and then dividing by the direct labor costs to determine an hourly overhead rate. The direct labor costs are found by multiplying the total direct labor hours by the labor rate. Finally, the total overhead cost for each product is found by multiplying the direct labor costs for each product by the hourly overhead rate (Chang 2005).

In Figure 1 below the cost for each product produced is broken down into material, direct labor and overhead costs. Also, the breakdown of the overhead costs and overhead rate is shown. The detailed data used to develop the costs can be found in the monthly product and cost summary located in Appendix A.

Standard Unit Costs

Product Lines

Valves

Pumps

Flow Controllers

Monthly Total

Material

$16.00

$20.00

$22.00

$458,000

Direct Labor

$4.00

$8.00

$6.40

$155,600

Overhead

(Overhead Rate x Direct Labor)

$17.55

$35.10

$28.08

$682,688

Standard Unit Costs

$37.55

$63.10

$56.48

Manufacturing Overhead

Receiving

$20,000

Materials Handling

$200,000

Engineering

$100,000

Packing and Shipping

$60,000

Maintenance

$30,000

Machine Depreciation per Hour of Use (Units-of-Production Method)

$270,000

Set-Up Labor

$2,688

Total

$682,688

Overhead Rate (Total Overhead Costs / Direct Labor Costs)

4.39

Figure 1: Standard Unit Costs (Traditional Method)

A clue to the leadership team at Destin that the traditional method currently used for costing is not sufficient is that their pump prices are not competitive in the market, without slashing their profits, and their flow controller prices appear to be well below the market price with a 35% margin and at higher price points sales have not slowed. A brief glance at the monthly summary data located in Appendix seems to provide a clue as to the cause of the issue. The engineering time and number of transactions required for material handling and packing and shipping the flow controllers is significantly more for flow controllers. A costing method that evenly distributes these indirect costs will artificially make the flow controllers look less expensive to produce and unfairly penalize the other products.

Once the team at Destin Brass realized that the current costing method was not accurately allocating the overhead costs by how the costs were accrued they began discussing how best to assign the costs accurately. Destin first discussed separating the material related overhead, such as the cost of receiving and handling material, and allocated that to the product line based on the cost of material and justified this because material handling does not have any relationship with the labor cost of machining. Set-up labor costs were also separated from the total overhead and allocated to each product line. Again, set-up labor has not correlation with the total labor cost of a production run. Last, machine hours were substituted for labor hours as a method for allocating the remaining factory overhead hours on the basis that machine costs are estimated to be double that of labor hours (Bruns 1989).

Figure 2 below shows the unit cost of the revised costing method. While dividing the indirect material costs by material usage appears to be a logical approach, this method would still be considered a hybrid traditional approach since the costs are applied to the products based on activity levels required to produce each product.

Revised Unit Costs

Product Lines

Valves

Pumps

Flow Controllers

Monthly Total

Material

$16.00

$20.00

$22.00

$458,000