Reference no: EM139665

Make-or-Buy Decision Curtis Corporation is beginning in manufacture Mighty Mint, a new mouthwash in a small spray container. The product will be sold to wholesalers and large drugstore chains in packages of 30 containers for $18 per package. Management allocates $200,000 of sited manufacturing overhead costs to Mighty Mint. The manufacturing cost per package of 30 containers of expected production of 100,000 packages is as follows;

Direct material	$6.50
Direct labor	3.5
Overhead (fixed and variable)	3
Total	$13.00

 

	Model 501	Model 541	Model 599
Selling price	$5,000	$10,000	$13,000
Unit cost:
Material	1,050	4,500	6,000
Direct labor	500	2,000	4,000
Overhead	769	3,077	6,154
Unit profit (loss)	$2,681	$423	($3,154)

Essentially, all overhead costs are fixed. Some of the fixed overhead costs are direct costs to particular models and others are common fixed costs.

Estimated total overhead

	Model 501	Model 541	Model 599	Total
Direct fixed	$4,000,000	$1,500,000	$500,000	$6,000,000
Common fixed				4,000,000
Total				$10,000,000

Lennon allocates overhead costs to products using a single overhead rate developed as follows. Estimated total overhead is divided by estimated direct labor cost. This results in an overhead rate per labor dollar. This rate is used to assign standard over-head to products. Below are estimates of sales and direct labor. These values simply an overhead rate of $1.5385 per labor dollar ($10,000,000 ÷ $6,500,000).

	Model 501	Model 541	Model 599	Total
Estimated unit sales	1,000	2,000	500	3,500
Estimated labor	$500,000	$4,000,000	$2,000,000	$6,500,000

Required

Because it is showing a loss, the controller of Lennon has asked you to analyze whether the Model 599 should be dropped. You should assume that direct fixed costs will be avoided if a model is dropped but common fixed costs will not be model is dropped.

Explain why the method used to allocate costs at Lennon results in "unreasonably high" charges to the Model 599 pump.