Suppose the economy is slow, and the firm has idle capacity at all production processes. (Remember that idle capacity costs are not included in the production costs shown above but are expensed as they occur.) Einstein decides not to produce product 2 until its market price rises again, because product 2 currently generates a negative ABC profit.
Einstein, Inc. produces a variety of basic metal products. The products are near-commodities, with prices determined by a competitive market, and there is little customer loyalty. Market prices tend to be volatile from month to month. Einstein has invested in highly flexible production processes, so that it can quickly shift its product mix to make whichever products yield the most profit, given current market prices and Einstein’s production costs. (These costs tend to be lower than competitors’ costs for some products but not for others).
Suppose that Einstein has a well-designed ABC system. Cost-data collection is highly automated, and managers at Einstein can easily access current activity-based cost estimates for any product.
Current selling price and full ABC cost per unit for five products are as follows:
1 2 3 4 5
Sales Revenue $500 $350 $480 $530 $435
ABC production cost 320 380 390 405 380
ABC gross profit 180 (30) 90 125 55
For simplicity, assume that these represent all the products that Einstein can currently make. Production costs include materials, labor (all production-related personnel, including engineers and production managers), variable overhead (electricity, supplies, etc.), and lease and depreciation costs for machinery and facility space. Costs in each of these categories are substantial. (Thus, for example, Einstein is not in the position that some companies are, of having almost no depreciation expenses.)
Is the firm using its accounting information appropriately to make product-mix decisions in each of the three scenarios below? If not, what would you suggest that they do differently? (If you think additional cost information is needed to make good decisions, explain what this information is and why it is necessary.)
a) Suppose the economy is slow, and the firm has idle capacity at all production processes. (Remember that idle capacity costs are not included in the production costs shown above but are expensed as they occur.) Einstein decides not to produce product 2 until its market price rises again, because product 2 currently generates a negative ABC profit.
b) Suppose the economy heats up, and the firm has more orders than it can handle. Adding capacity is not feasible in the short term. Einstein decides to produce as much of its most profitable products, 1 and 4, as it can sell, and as much of product 3 as it can fit into its production schedule after demand for products 1 and 4 is satisfied.
c) Suppose that the economic situation is as in (b): the firm has more orders than it can handle, and adding capacity is not feasible in the short term. Einstein decides that under these circumstances, ABC profits are not the right basis for making decisions. Instead, Einstein focuses on a measure they call margin 1, which equals revenues minus materials and labor, on the assumption that overhead allocations are not very relevant for their current short-term product-mix decisions. The firm therefore aims to make more of the products that provide higher margin 1 per unit.