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Joe Bell, president of DynaGolf, has called a meeting of the executive committee of the company's board of directors.
Joe Bell, president of DynaGolf, has called a meeting of the executive committee of the company’s board of directors. Joe is concerned about price competition and declining sales of one product line, the company’s DynaWedge series. Bell opened the meeting with a brief statement: As you know, we have set target prices for each of our product lines that will generate a 35 percent gross margin. With our DynaDriver product line, we have been able to achieve the target price. We have been able to achieve even higher prices than our target on the putter line, resulting in margins that are considerably higher than our 35 percent target. This is fortunate, because we have not met our goals with the DynaWedge. To give you some specific numbers, our target price for drivers is $162.61. We sell them, on average, at that price. Our target for wedges is $134.09, but competition has forced our prices to remain at an average of $125.96 no matter what advertising and promotion we do. Our putters have a target price of $81.31, but we’ve been able to raise the putter price to $105.70. To our surprise, our distributors seem fine with the higher prices and have not complained or moved business to our competitors.Joe Bell continued:Our factory is among the most efficient in the world. We use the latest technologies and our employees are highly skilled. This combination has given us a competitive advantage through manufacturing excellence and our products are used by a number of influential golf professionals. Our products are, in general, very successful, so, I have been concerned about our inability to hit our target price point for the DynaWedge. I suspect that some of our foreign competitors could be dumping wedges into the U.S. market, driving down both prices and unit sales. We have been hesitant to cut our wedge prices further for fear of eroding our overall gross margin. It is some comfort that we have been able to offset the bad DynaWedge news by raising the prices on our line of putters. We are lucky that our distributors have so readily accepted the putter price increases. We are even luckier, I believe, that none of our competitors has moved in with putter price discounts and poached our customers. I believe we could be vulnerable if our competitors wake up and recognize the opportunity.Steve Barber, a retired CPA who serves as an outside director, asks:Joe, I don’t pretend to know all that much about the details of the golf club industry, but let me ask you this: How confident are you in your product cost data? I’ve seen many companies in a variety of industries get into trouble because they just didn’t have a good handle on their costs. You rely on your costs as the basis for creating those target prices, so if your costs are off, your target prices will be off also, correct?Joe Bell responds:You make a good point, Steve. Frankly, I have been worried about just that issue. In recent years, we’ve substantially reconfigured the production plant and machinery. I’ve asked our controller, Phil Meyers, to dig into the cost build-ups for each product line and get back to me with a thorough analysis. I expect he’ll be able to do that over the next couple of weeks. My reason for calling this meeting was to let you know that this problem exists and that I am taking steps to address it. I don’t think we are at a crisis stage yet, but I could see this getting worse before it gets better. I’d like to get a handle on it at an early stage so we can plan whatever corrective actions are necessary and execute them carefully.More About DynaGolf’s Product LineDynaGolf holds four patents on a unique golf club head design that forges three different metals; steel, titanium, and brass; into one club head. Each metal contributes different elements to the club head’s performance. The three metals have different weight and density profiles. When they are incorporated into DynaGolf’s patented design, they produce a club head that has appealing characteristics (swing speed, club feel, and moment of inertia) that differ from competitors’ clubs. Experienced golfers find they can get superior distance and control with DynaGolf’s clubs, and that leads to lower scores and happier golfers.Although DynaGolf’s club head design is protected by patents, it is so popular that competing manufacturers have worked diligently using similar materials and their own designs to create club heads that do not infringe on the patents but that have the look, feel, and performance of a DynaGolf club head.DynaGolf’s first big success was its line of drivers. It became an overnight hit when a professional golfer won a major tournament while using the club. All of the major golf magazines did stories on DynaGolf and product demand tripled in one month. The DynaDriver is sold to a single distributor that adds the shaft, grips, and other components, then sells the driver to pro shops at golf courses and golf specialty stores, where the drivers retail for between $350 and $500.After seeing the success of its driver, DynaGolf introduced a line of putters that used the three-metal fusion design, followed by a line of wedges that have a similar composition. The wedges are sold to three different distributors and the putters are sold to six different distributors. Specialty putters such as the DynaPutter retail between $120 and $200 in pro shops and specialty golf retail outlets. The wedges sell in approximately that same price range.Details of the Club Head Production ProcessAll three types of clubs (drivers, wedges, and putters) go through the same manufacturing process, but the time it takes to make each type of club and the amount of material that goes into each club varies by product line. Each club includes between 5 and 10 components. A component is a precisely machined piece of steel, titanium, or brass that DynaGolf buys from outside suppliers.A setup machinist positions the components in a jig, then places the jig into a specially designed computer-controlled machine. Under the control of a machine operator, the machine first heats the components so the metals begin to melt. This fuses the three metals into a single unit. The machine then cools the metal, allowing the machine operator to activate metal brushes, which polish the finished club head.The factory is organized into five departments: Receiving, Engineering, Setup, Machining, and Packing. Before a production run begins, Receiving department employees issue a separate order for each component to be used in the club head. When each element arrives, it is inspected by a Receiving employee.The staff of Engineering makes sure that the finished club heads meet the product specifications and maintains the operating efficiency of the fusing/cooling/polishing machines. Because the production process requires an extremely high level of precision, the Engineering department often has to issue engineering change orders when components arrive with dimensions that are slightly outside of specified tolerances.The process begins with Setup machinists clearing residue from the machine and the jigs. After cleaning all of the parts, they adjust the machine’s settings to match the type of club to be produced in the next run and make a few club heads to ensure that the machine is operating properly and the jigs fit tightly. Once a machine is operating properly with a given set of jigs and tools, it will be used for a production run of between 500 and 10,000 club heads before repeating the cleaning and setup operations for a different production run. The Machining department has several of these machines, any of which can be used to manufacture any of the three product lines once it is configured with the correct set of jigs and tools. The following table summarizes DynaGolf’s production activities for a typical month of operations:DynaGolf Production Activities SummaryProduction (in units) 10,000 for Driver, 15,000 for Wedges and 5000 for putterNumber of production runs1 for Driver, 3 for Wedges and 10 for PutterFor example, DynaGolf manufactures a total of 15,000 wedges in three separate production runs of 5,000 wedges each. The drivers are produced in one production run because they are the largest club, which makes the setup process difficult. The machinist prefer to do fewer of these difficult setups.A Packing department employee places each club head in bubble wrap, then packs it into a box with partitions that help prevent the heads being damaged during shipment. Then, a Packing employee seals the boxes, prints shipping labels, and gets the boxes palletized and onto an outgoing truck for delivery. Since the drivers are made all in one production run and they all go to one distributor, Shipping puts all 10,000 units into one shipment a month. Details of the Shipping department activities for a typical month appear in the following table:DynaGolf Shipping Department Activities SummaryShipments (in units) 10,000 for Driver 15,000 for Wedges and 5,000 for putterNumber of shipments 1 for Diver, 5 for Wedges and 20 for putterDynaGolf’s Cost Accounting SystemThe raw material in this process are the club head components, which are fused into a finished club head in the Machining department Drivers use 5 components, wedges require 6 components, and putters require 10 components.Labor includes the machinists’ time doing setup labor, which is required before the production process can begin, and the machine operators’ time during the production run itself. Both machinists and machine operators cost $20 per hour. The production run also consumes machine hours. The raw materials, labor, and machine hours used in the process are summarized in the following table:DynaGolf Machining Department Activities SummaryRaw materials Components required per unit 5 for Driver, 6 for Wedges and 10 for PutterCost per component $4 for Driver, $5 for Wedges and $1 for PutterTotal raw materials cost per unit $20 for Driver, $30 for Wedges and $10 for PutterLabor cost (at $20 per hour) Setup labor (per production run) 10 hrs for Driver, 10 hrs for Wedges and 11 hrs for PutterRun labor (per club head) 1/2 hr for Driver, 1/3 hr for Wedges and 1/4 hr for PutterMachine hours (per club head) 1/4 hr for Driver, 1/3 hr for Weges and 1/2 hr for PutterDrivers take more run labor time because a machine that is producing drivers can require more than one machine operator at a time. In contrast, the putters are so much easier to make that a single machine operator can often run two machines at once.The Machining department has a total budget of $700,000 in a typical month, which includes depreciation and maintenance on the machines and the cost of the electricity to run them. This, and other totals for departmental overhead, appear in the table below:DynaGolf Departmental Overhead Totals (in $000)Receiving department 300 Engineering department 500 Machining department 700 Packing department 200 Setup department 3 Total manufacturing overhead 1,703 The Controller’s ReportA week after the executive committee meeting, Phil Meyers, the company’s controller, met with Joe Bell to discuss Phil’s findings. Phil begins:Joe, as you know, our current accounting system assigns the raw material costs of the components and the run labor to the three types of clubs each month. We treat setup labor as indirect labor and include it in overhead. Using these procedures, we calculate our product costs for drivers to be $105.70, for wedges to be $87.16, and for putters to be $52.85. This approach has been pretty standard in most light manufacturing industries for years, but there are some other options.I have been studying our system, as you know, and I’m beginning to worry that our overhead rate is getting out of line. We are applying an awfully large chunk of money based on direct labor cost (the overhead application rate is over 750 percent), and I’m not sure that the direct labor cost drives very much of that overhead given our current manufacturing facilities. When we started this business, we were doing most of the club building by hand. Now that we’re using those machines, less of the cost is direct labor. Essentially, by replacing labor with the machines, we’ve replaced labor costs with capital or overhead dollars. I think the logical chain of labor causing the overhead cost is no longer valid here.I did look closely at Engineering, too. That department schedules its staff based on engineering change orders. Drivers are pretty standard now that we have the bugs ironed out of the process, so they only generate 25 percent of all engineering change orders. The wedges cause about 35 percent of them. But the putters, which go through our most complex process, are responsible for all of the other engineering change orders. We are still working out a number of kinks in the putter process, too.Based on all of these findings, I’m going to recommend that we change the accounting system along the following lines:1. Pull setup labor out of the overhead accounts and assign it directly to each product line. We know how much time we are spending to set up each machine for each club head run, so we could use that information to assign the costs directly. The direct assignment of these costs makes sense to me.2. We are allocating Receiving department costs on direct labor dollars, but I think it makes more sense to allocate that cost using raw materials dollars. The work they do in Receiving increases or decreases with the quantity and value of the materials coming in, so I think that would be a better proxy for our cost consumption in that department.3. I believe we should allocate the remaining overhead (after we take out Setup and Receiving) using machine hours. I just think it captures the activities in our current operation better than using direct labor dollars does now.If we make these three changes, I believe we’ll get a much better idea of what each of these clubs is costing us to make, which will let us get a better idea of what a good target price should be.Joe Bell scratches his chin and looks up thoughtfully before responding:I appreciate the work you put into this. I know you were pulling some pretty late nights to get this information collected and analyzed in a week. These seem to be some pretty major changes to the accounting system, but I have a lot of confidence in your judgment.Let me think these over for a few days. I might give Steve Barber a call and get his input before I make a decision. I’ll let you know by the end of the week if I think we can move ahead on these changes.QUESTIONS1. Calculate the per-unit costs for each product using the current system.2. Calculate the per-unit costs for each product using Phil Meyers’ proposed system.3. Calculate the per-unit costs for each product using activity-based costing.