Allocating Fixed Costs, Herrestad

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The Herrestad Company has a classic problem: two products that use fixed overhead disproportionately ("Activity based costing", n.d.). That is, according to the data given in Table A below, product A uses more production runs and more sales reps than product B. Also, there are far fewer units of Product A, meaning that each unit requires a great deal of overhead resources to support. Although the sales price of Product A is high, and therefore one might think that they are charging enough to carry all this extra overhead attention, but profitability analysis indicates otherwise. Table A Use of fixed overhead resources by product line Productionruns(not$) Numberofsalesreps(not$) Total 100 25 ProdA 65 15 ProdB 35 10 Profitability will be reviewed in two parts, first we will analyze the contribution margin, and then product line profitability overall, including fixed costs. Contribution margin is the sales price less the variable costs, that is, the costs that go up with each extra unit produced ("Contribution margin", n.d.). In this case, there are four variable costs as shown in Table B below: direct material, direct labor, variable overhead, and variable selling and administrative costs. Contribution margin is important because it reveals how much profit is generated because of the sales price and incremental costs of making the units. That is, the profit at the unit level. As you see from Table B, Product Bs contribution margin is almost twice that of Product A. That is, while Product B shows a 31.1 percent contribution margin, Product A has only a 15.7 percent contribution margin. Table B Contribution margin: Beginninginventory Unitsproduced Unitssold Per unit profits by product line Total $ 10,000.00 8,000.00 Total $250.00 ProdA ProdB 2,500.00 2,000.00 ProdA $460.00 7,500.00 6,000.00 ProdB $180.00 Selling per price unit Variable costs per unit Directmaterial

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