Ajax Manufacturing Company (Ajax) is a company engaged in the manufacturing of industrial products (herein referred to as Products A, B and C).
Ajax wishes to maintain an average gross margin of 35% across all its products by employing a traditional cost accounting method. This method adds the unit cost of raw materials, unit cost of labor, unit overhead costs computed by summing all overhead costs and then dividing by allocated labor hour use, and a 35% gross margin. This approach has earned the company varied results such that it has been able to sell 10,000 units of Product A at a 35% margin, Product B at 15,000 units at a reduced price resulting in a 31% margin, and 5,000 units of Product C at a 50% margin.
The managers of Ajax are concerned about the mixed results, suspecting that competitors are flooding the market with Product B but are bullish at keeping prices above competitor prices, while being unable to explain why Product C remains an unattractive market for competition despite the market buying Product C at a higher price.
The company’s controller took the initiative to draw a “modern” approach. His modification varied in three ways; labor hours are allocated based on units produced, materials are charged based material cost rather than labor costs, and machine hours are used instead of labor hours as the divisor to allocate production volume.
This approach varies from the transactions-based cost accounting used by today’s firms. How is Ajax performing if a transactions-based approach to cost accounting is used and what changes, if ever would be employed for Ajax to remain competitive?
Ajax Manufacturing Company (Ajax) produces three products A, B and C for industrial use. Ajax uses a traditional approach to determining the manufacturing cost and adds a 35% margin to determine the selling price. The managers of Ajax are naturally concerned about the financial performance of the company, after experiencing significant decline in the volume of Product B sold, the absence of competition in a small-volume market with a high gross margin, and the inconsistency between actual and projected results have resulted in a modification of the approach to a “modern”, machine-usage based costing.
However, the use of current transactions-based costing shows the real picture. Ajax realizes the highest gross margin from Product A and suffers the most from the continued production and sale of Product C at traditional cost levels.
Ajax may optimize its revenues by continuing to manufacture and sell Product A at its current price (162.61), manufacture and sell Product B as low as 119.76 to increase market share and receive a 35% gross margin, and either discontinue manufacturing of Product C or increase selling price to 261.29 to retain a 35% gross margin.
Ajax Manufacturing Company (Ajax) produces three products A, B and C for industrial use. Ajax uses a traditional approach to determining the manufacturing cost and adds a 35% margin to determine the selling price. The calculations and product notes are shown below.
1. Product B is the largest in terms of volume sold (among the three) but is already a significantly lower number due to pressure from competitors. Ajax’s facilities are at par with other producers, so management believes that competitors are dumping similar products.
2. Competition has not challenged Product C, even as Ajax charged higher prices for it. However the volume sold is the lowest.
3. The contribution of each product to net income is shown below.
A modern approach to cost accounting was undertaken by the company’s controller. His calculations are shown below.
The calculations do not depart completely from a volume-driven calculation of manufacturing costs. However, this set of calculation takes into account the shift from labor hours to machine hours as a determinant of non-direct overhead costs. These calculations provide the following net income and profit contribution results.
The calculations show that continuing to manufacture Product C will negatively affect net income, while products A and B exceed the 35% gross margin requirement.
Conclusions and Recommendations
The following recommendations are derived from the summary calculation shown below.
1. Transactions-based costing shows the real manufacturing cost based by assigning overhead costs relevantly. The calculations show that Ajax produces Product A the cheapest and Product C the highest.
2. Transactions-based gross margins show that Product A provides a 62% return, which is eroded by the manufacture of Product C.
3. Discontinuing the manufacture of Product C gives a net income of about 1.7 M, retaining the line decreases net income by 9,000.
4. If Ajax wishes to continue producing all three products at 35% gross margin, it should sell A at 95.42, B at 119.76 and C at 261.29.
5. However, for Ajax to optimize its revenues, it should only reduce the price of B to 119.76 to increase market share, and sell Product C at 261.29 or discontinue its production if prices fall below 169.84/unit. It will be unwise for the company to continue producing and selling Product C using the traditional cost calculation.