Problem

Madison Electric Pump Corporation manufactures electric pumps for commercial use. The company produces
three models, designated as regular, advanced, and deluxe. The company uses a job-order cost accounting
system with manufacturing overhead applied on the basis of direct-labor hours. The system has been in place
with little change for 25 years. Product costs and annual sales data are as follows:

Regular
Advanced Model Deluxe Model
Model

Annual sales (units) 20,000 1,000 10,000

Product costs:

Direct material $ 20 $ 50 $ 84

20 (1 hr.
Direct labor 40 (2 hr. at $20) 40 (2 hr. at $20)
at $20)

170 (1 hr.
Manufacturing overhead* 340 (2 hr. at $170) 340 (2 hr. at $170)
at $170)

Total product cost $210 $430 $464

*The calculation of the predetermined overhead rate is as follows:

Manufacturing-overhead budget:

Depreciation, machinery $2,960,000

Maintenance, machinery 240,000

Depreciation, taxes, and insurance for factory 600,000

Engineering 700,000

Purchasing. receiving and shipping 500,000

Inspection and repair of defects 750,000

Material handling 800,000

Miscellaneous manufacturing overhead costs 590,000

Total $7,140,000

Direct-labor budget:

Regular model: 20,000 hours

Advanced model: 2,000 hours

Deluxe model: 20,000 hours

Total 42,000 hours

For the past 10 years the company's pricing formula has been to set each product's target price at 110 percent
of its full product cost. Recently, however, the regular-model pump has come under increasing price pressure
from offshore competitors. The result was that the price on the regular model has been lowered to $220.
The company president recently asked the controller, "Why can't we compete with these other companies?
They're selling pumps just like our regular model for $212. That's only two bucks more than our production
cost. Are we really that inefficient? What gives?"
The controller responded by saying, "I think this is due to an outmoded product-costing system. As you may
remember, I raised a red flag about our system when I came on board last year. But the decision was to keep
our current system in place. In my judgment, our product-costing system is distorting our product costs. Let me
run a few numbers to demonstrate what I mean."
Getting the president's go-ahead, the controller compiled the basic data needed to implement an activity-based
costing system. These data are displayed in the following table. The percentages are the proportion of each cost
driver consumed by each product line.

Product
Lines
 Cost Regular Advanced Deluxe

Activity Cost Pool Driver Model Model Model

I: Depreciation, machinery Machine time 39% 13% 48%

Maintenance, machinery

II: Engineering Engineering hours 47% 6% 47%

Inspection and repair of defects

Number of material
III: Purchasing, receiving, and shipping 47% 8% 45%
orders

Material handling

IV: Depreciation, taxes, and insurance for

Factory space usage 42% 15% 43%
factory

Miscellaneous manufacturing overhead

Required:
1. Compute the target prices for the three pump models, based on the traditional, volume-based product-
costing system.

2. Compute new product costs for the three products, based on the new data collected by the controller. Round
to the nearest cent.

3. Calculate a new target price for the three products, based on the activity-based costing system. Compare the
new target price with the current actual selling price for the regular model pump.

4. Write a memo to the company president explaining what has been happening as a result of the firm's
traditional volume-based product-costing system.
5. What strategic options does management have? What do you recommend, and why?

Step-by-step solution
1. Step 1 of 1
1.

Regular Advanced Deluxe

Model Model Model

Product costs based on traditional, volume-based

$210.00 $430.00 $464.00
costing system

× 110% × 110% × 110% × 110%

Target price $231.00 $473.00 $510.40

2. Product costs based on activity-based costing system:

Regular Advanced Deluxe

Model Model Model

Direct material $20.00 $50.00 $84.00

Direct labor 20.00 40.00 40.00

Machinery depreciation and maintenancea 62.40 416.00 153.60

Engineering, inspection and repair of defectsb 34.08 87.00 68.15

Purchasing, receiving, shipping, and material

30.55 104.00 58.50
handlingc

Factory depreciation, taxes, insurance, and

24.99 178.50 51.17
miscellaneous overhead costsd

Total $192.02 $875.50 $455.42

aPool I:

Depreciation, machinery $2,960,000

Maintenance, machinery 240,000

Total $3,200,000

Regular: ($3,200,000 × 39%)÷ 20,000= $ 62.40

Advanced: ($3,200,000 × 13%)÷ 1,000= $416.00

Deluxe: ($3,200,000 × 48%)÷ 10,000= $153.60

bPool II:

Engineering $700,000

Inspection and repair of defects 750,000

Total $1,450,000

Regular: ($1,450,000 × 47%)÷ 20,000= $34.08

Advanced: ($1,450,000 × 6%)÷ 1,000= $87.00

Deluxe: ($1,450,000 × 47%)÷ 10,000= $68.15

cPool III:

Purchasing, receiving, and shipping $500,000

Material handling 800,000

Total $1,300,000

Regular: ($1,300,000 × 47%)÷ 20,000= $30.55

Advanced: ($1,300,000 × 8%)÷ 1,000= $104.00

Deluxe: ($1,300,000 × 45%)÷ 10,000= $58.50

dPool IV:

Depreciation, taxes, and insurance for factory $600,000

Miscellaneous manufacturing overhead 590,000

Total $1,190,000

Regular: ($1,190,000 × 42%)÷ 20,000= $ 24.99

Advanced: ($1,190,000 × 15%)÷ 1,000= $178.50

Deluxe: ($1,190,000 × 43%)÷ 10,000= $51.17

3.
 Regular Deluxe
AdvancedModel
Model Model

Product costs based on activity-based costing

$192.02 $875.50 $455.42
system

× 110% ×110% ×110% ×110%

New target price $211.22 $963.05 $500.96

The new target price of the regular model, $211.22, is lower than the current actual selling price,
$220.

4.Memorandum

Date: Today

To: President Madison Electric Pump Corporation

From: I.M. Student

Subject: Product costing

Based on the cost data from our traditional, volume-based product-costing system,
our regular model is not very profitable. Its reported actual contribution margin is
only $10 ($220 – $210). However, the validity of this conclusion depends on the
accuracy of the product costs reported by our product-costing system. Our
competitors are selling motors like our standard model for $212. This price suggests
that their product cost is substantially below our previously reported cost of $210.
Our new, activity-based costing system reveals serious product cost distortions
stemming from our old costing system. The new costing system shows that the regular
model costs only $192.02, which implies a target price of $211.22. This price is lower
than our current actual selling price and roughly consistent with the price our
competitors are charging.
In contrast, our new product-costing system reveals that the advanced model's
product cost is $875.50 instead of the previously reported cost of $430. The new
product cost suggests a target price of $963.05 for the advanced model, rather than
$473, which was our previous target price for the advanced model.
 5. The company should adopt and maintain the activity-based costing system. The
price of the regular model should be lowered to the $212. Lowering the price should
enable the firm to regain its competitive position in the market for the regular model.
Further price cuts should be considered if marketing studies indicate such a move will
increase demand.
The price of the advanced model should be set near the target price of $963.05. If
the advanced model does not sell at this price, management should consider
discontinuing the product line. Input from the marketing staff should be sought
before such an action is taken. An important consideration is the extent to which sales
in the regular model and deluxe model markets depend on the firm's offering a
complete product line.
A slight price reduction should be considered for the deluxe model (from $510.40
down to $500.96). However, the product cost distortion from the old costing system
did not affect this model as seriously as it did the other two.

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