Destin Brass Company's Future Costing and Pricing Approach
Destin Brass Products Company manufactures valves, pumps and flow controllers, all three of which are used in water purification systems. Every month, it becomes clearer through their profit reports that there are strategies that other companies are using because despite the fact that these other companies sell pumps at low prices, they are still able to make profits. In a meeting that was held to come up with possible suggestions to work around the problem, they realized that competitors had not yet looked into the opportunities for profit in flow controllers and still made considerable sales and profit even with 12 per cent price increments. They decided to adopt a new system that assigns the cost of each activity resource to all products and services according to the direct consumption by each. It is recommended that since Destin does not have any threatening competition in the flow controller market, the prices of these products could be easily raised to $3 per unit to produce a 35 per cent profit margin. They should look at cutting costs of the components that it uses to create these products. If well analyzed, a single pump takes five components to produce at a cost of $20, while flow controllers take twice as many for only $2 more in material costs and in addition, the company may look to increase its profit margins by increasing the number of production runs for valves. In conclusion, Destin should evaluate the costs of implementing this new method of cost accounting and discuss among them whether it would really be feasible to introduce it into the company operations.
Destin Brass Company's Future Costing and Pricing Approach
Destin Brass Company was established in 1984 by Abbott, Guidry and Scott in a commercial machine shop purchased around the same time. After a conversation with the president of a company known for its manufacture of many types of water purification equipment, who was not satisfied with the quality of brass valves available, Steve Abbott sensed a lucrative opportunity that would solve this particular problem and make him profits as well. He then approached John Scott who was a local legend due to his ability to manufacture high quality brass boat fittings for the fishing fleets along the Florida Gulf coast. He was able to quickly analyze the nature of problems that other manufacturers were having with their water purification valves and realized that the tolerances were small hence required great labor, skill and expensive machines controls to maintain.
Soon after the formation of the company, Scott and his team were able to manufacture valves that met or exceeded the needed specification enabling them to acquire a contract with the purification equipment manufacturer enabling them to make some money from the market. Furthermore, this allowed the company to specialize in brass as they could make use of Scott's excellent skills at working with this material. Ronald Guiry was included in the partnership because he has a long record of administrative successes which would be invaluable to the administrative unit of the company. An accountant, Peggy Alford, who also had manufacturing experience, was then selected by the three to join the company. Soon, the company grew quickly as the demand for water purification equipment increased and soon Destin Brass Company became the only supplier of valves to its customers.
Considering that the same manufacturing skills used in machining valves could be used in manufacturing brass pumps and flow controllers, Abbot and Guidry became ambitious and created an engineering department designed to come up with new products for their markets. They capitalized on the fact that pumps (amounting to 55 per cent of their total revenue) had an even larger market than the valves (amounting to 24 per cent of their total revenue) they were producing and knowing all too well that flow controllers (amounting to 21 per cent of their total revenue) were often used in the same fluid distribution systems as valves and pumps, they also began producing them as well. As a result, the company became a modern job shop that specialized in purchase of brass foundries that they later machined and assembled in the company's modern manufacturing facility using the same labor and machines for all their three product lines.
Monthly production of valves took place in a single run because the expense of precise machining made the cost of Destin's valves too high to compete in the non specialized valve market. At the time although Scott felt that several competitors could match Destin's quality in valves, none had tried to gain market share by cutting their prices and gross margin were maintained at a standard 35%. The number of companies producing pumps was high, the market was large and specifications for their development were less precise. Each month brought in new reports of reduced prices and Destin had no choice but to match this new process by lowering its prices or losing its place as a supplier of pumps and as a result, gross margins on the sale of pumps fell to 22 per cent below the original planned 35 per cent (Exhibit 1).
The company members did not understand how these other companies could be making profits at their current prices unless their pumps were being subsidized by other products. Flow controllers required more labor but in the recent months, Destin had manufactured more of them and shipped a greater number to customers in various countries than it had done with pumps and valves. It was not until Destin increased the prices of flow controller prices by 12 per cent with no apparent effect on their demand that Abbott realized that they had almost no competition in the flow controller market.
Cost accounting is a basic skill that enables the understanding of how product costs can be measured and allowed for. In any manufacturing business, material and labor costs have a clear and direct relationship to the products produced, at whichever stage that they are incurred be it during product design or afterwards. Hence different companies employ the use of the concept in different ways to enable them make profits while still being able to reduce the prices of their products. In so doing, they make different assumptions about their overhead costs or they just allocate them to products in a different way in a situation where prices have to be high enough to provide margins that cover corporate costs and produce profits to their owners.
The type of accounting system (labor) used is fundamental in determining the difference between the standard unit costs and the revised unit costs. The standard unit costs were calculated using a cost accounting system that meets all the needs for preparing financial reports and tax returns. It is based on measured of direct and indirect costs and on assumptions of the production and sales activity of the company. Each unit produced is charged for material cost based on the prices we pay for the components and labor cost based on the standard times for run labor times the labor rate assigned at a particular rate per hour. Overhead cost is then assigned to products in a two stage process than begins with the overhead costs being assigned to production after which in the second phase the total overhead cost is assigned to production on the basis of production run labor cost.
Activity based costing identifies activities in a company and assigns the cost of each activity resource to all products and services according to the direct consumption by each, assigning more indirect costs-the overheads, into direct costs. Allowing the company to precisely estimate the cost of individual products and services for the purpose of lowering the prices of those which are overpriced hence understanding product and customer cost and profitability. In this revised or modern accounting system, overhead costs that cannot be traced directly to product lines should be allocated on the basis of transactions because it is these transactions that cause the costs to be incurred in the first place. Hence, a product that requires three times as many transactions to be incurred than the other products would be allocated three times as much of the overhead costs allocated to those transactions than the other products would be. Hence each product would be allocated an overhead cost that is equivalent in ratio to the number of transactions that are required to complete its production process. In that way, a product that causes 3 per cent of the total transactions for receiving its components and completing its production process would be allocated 3 per cent of the total cost of receiving components.
This has strategic implications in that much as product cost should have more to do with the costs caused by producing and selling the product, most of these overhead costs may not operate by these same principles. This translates to the fact that activity in the form of transactions and operations cause the company to incur costs and not the production volume as such. Thus if a clear understanding of this approach to costing is understood then companies will be in a better position to produce goods while still making profits.
Hence I recommend that Destin Brass Products Company should adopt the new system of accounting and change the way it is currently doing its costing. Each product should have defined transactions which should all be well documented after which a weighted costing is done for all the products as per this new approach. This will ensure their place in the market even when the prices for producing pumps fall that they are not making any profits at all. By being able to produce more flow controllers that have a higher number of transactions, they will be able to make the production of pumps seem relatively cheap, hence they will be able to reduce their market which will in turn increase their sales volume as customers will be interested in their products which finally enables them to enjoy profits due to economies of large scale production.
The method of costing that the company currently uses based on direct labor dollars finds the standard cost per units of valves to be $37.56, pumps to be $63.12 and flow controllers to be $56.50 (Exhibit 3). If Destin Brass Products were to switch to the new method of activity based costing then the cost per unit for valves would be $47.17, pumps would be $51.64 and flow controllers would be $74.22 increasing the costs of producing valves by 20.37 per cent, reducing the cost of producing pumps by 22.23 per cent and increasing the cost of producing flow controllers by 35.38 per cent. Unit costs that are incurred when the overhead rates for receiving and shipping of materials is not included in the overhead costs has also been done, realizing an increase of 23.35 per cent for valves, a reduction of 7.07 per cent for pumps and a decrease of 17.81 per cent from the standard. These still vary greatly from the costs arrived at using the activity based method due to the fact that different methods are used to allocate overheads.
The revised costs brings in the concept of machine hours whereby the same amount of overhead is applied to a unit cost of a pump as to a unit cost of a valve, while applying little overhead to the flow controllers. If actual production process is analyzed, the number of transactions required in the production of flow controllers is high (78 per cent) with actual machine hours being used only amounting to 7 per cent. The standard method may not give an accurate overview of the whole situation as they show that valves are only contributing 35 per cent towards gross profits when by using the activity based method, they are seen to contribute only 18 per cent towards the gross profits; pumps are seen as contributing towards 36 per cent of the profits (Exhibit 4).
Conclusion and Recommendations
Since Destin does not have any threatening competition in the flow controller market, the prices of these products could be easily raised to $3 per unit to produce a 35 per cent profit margin. The company could also carefully increase the costs of its valves of course keeping in mind that if the prices rise too high then customers may look elsewhere for their products. The company should consider maximizing its profit in the low competition flow controller market to offset the less profitable valve market and to keep on competitive in the pump market; Destin should look at cutting costs of the components that it uses to make these products. If well analyzed, a single pump takes five components to produce at a cost of $20, while flow controllers take twice as many for only $2 more in material costs (Exhibit 2).
The company may look to increase its profit margins by increasing the number of production runs for valves; this large scale production may expand its customer base because if Destin Brass Products stops producing valves then the overhead costs for machine depreciation and maintenance would have to be soaked up by the two other product lines, eventually making their unit costs higher and business less profitable.
Destin should evaluate the costs of implementing this new method of cost accounting and discuss among them whether it would really be feasible to introduce it into the company operations.
Horngren, C, T 1987, Cost Accounting, 2nd edn, Pearson Education
Harvard Business College, Destin Brass Products Company,
Exhibit 1: Product Profitability Analysis
Exhibit 2: Monthly Product and Cost summary
Exhibit 3: Standard Unit Costs
Exhibit 4: Revised Unit Costs
Exhibit 5: Monthly Overhead Cost Activity Analysis
Shim, K, J and Siegel J, G 2000, Financial Management, 2nd edn, Baron's Educational Series
Van Horne, J and Wachowicz, M 2005, Fundamentals of Financial Management, 12th edn, Financial Times, Prentice Hall