Cost Allocations Can Change the Relative Profitability of Products

question 9

Essay

Cost Allocations can Change the Relative Profitability of Products
Woodley Furniture is a small boutique manufacturer of high quality contemporary wood tables. They make two models: end tables and coffee tables in a variety of different woods and finishes. Current annual production of end tables is 8,000 units that sell for $250 and have variable cost of $120 each. Current annual production of coffee tables is 6,000 units that sell for $475 and have variable cost of $285 each. Woodley has fixed costs of $2.4 million. Woodley sells all the tables they produce each year.
Required:
a. Calculate total firm-wide profits and product-line profits for the end tables and coffee tables after allocating the fixed costs to the two product lines using sales revenues as the allocation base.
b. Which of the two products is the most profitable based on total profits (after allocating fixed costs)? Is Woodley making an adequate profit?
c. Woodley management decides to add a dining table to its product offerings. The plant currently has excess capacity, so no additional fixed costs are required to produce the dining tables. The new dining table will not affect the number of units sold or prices of the existing coffee and end tables. They expect to sell 4,000 dining tables at a price of $620 each, and variable cost per table is $500. Calculate total firm-wide profits and product-line profits for the end tables, coffee tables, and dining tables after allocating the fixed costs to the three product lines using sales revenues as the allocation base.
d. Analyze the profitability of the three products and firm-wide profits calculated in part (c) compared to the profitability of the two products alone and firm-wide profits in part (a).
e. Recalculate your answers to parts (a) and (c), but, instead of allocating the $2.4 million of fixed costs using sales revenues as in parts (a) and (c), allocate the $2.4 million of fixed costs using the total contribution margin of each product (total sales revenue less total variable cost).
f. Discuss the relative advantages and disadvantages of using total contribution margin to allocate the fixed costs in part (e) relative to using sales revenues to allocate the fixed costs, as in parts (a) and (c).

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