Halden Precision: The Misapportioned Profitability Report
Halden Precision is a small jobbing engineer with two product lines, A and B. Machine hours are the company's scarce resource (7,000 hours a month in total) and its accounting policy apportions production overheads on machine hours. A new trainee prepared last month's product profitability report on a direct labour cost basis, apportioning $105,000 of production overheads. Her report showed: Product A - sales $200,000, materials $80,000, direct labour $40,000, profit $38,000; Product B - sales $150,000, materials $40,000, direct labour $60,000, loss $13,000. Machine hours recorded were A 2,000 and B 5,000. The report reached the board twelve days after the month end with no commentary. The sales director has circulated it with a covering note: 'B must be discontinued.'
1. Recompute the profit or loss of each product on the company's stated policy and quantify the effect of the trainee's error.
Read the worked answer
Trainee's basis (direct labour cost): total labour $100,000. A = 40,000/100,000 = 40% × $105,000 = $42,000; B = 60% × $105,000 = $63,000. Her profits (A $38,000; B $(13,000)) are arithmetically correct but on the wrong basis.
Correct basis (machine hours): total 7,000 hours.
- A: 2,000/7,000 × $105,000 = $30,000
- B: 5,000/7,000 × $105,000 = $75,000
Corrected results
| A | B | |
|---|---|---|
| Sales | 200,000 | 150,000 |
| Materials | (80,000) | (40,000) |
| Labour | (40,000) | (60,000) |
| Overhead | (30,000) | (75,000) |
| Profit/(loss) | 50,000 | (25,000) |
Total profit is unchanged at $25,000 - the error only redistributes overhead. The mistake overstated A's profit by $12,000 and understated B's loss by $12,000. Note that the error actually flattered B, so correcting it makes the case for closure look stronger on an absorption basis - which is precisely why absorption profit is the wrong number to decide on.
2. Using contribution per unit of the scarce resource, advise the board whether Product B should be discontinued, and state what further information you need.
Read the worked answer
Contribution analysis
- A: 200,000 − 80,000 − 40,000 = $80,000 over 2,000 hours = $40 per machine hour
- B: 150,000 − 40,000 − 60,000 = $50,000 over 5,000 hours = $10 per machine hour
Both products generate positive contribution. Closing B does not save the $105,000 of overhead (it is apportioned, not caused by B), so profit would fall by $50,000 unless the 5,000 freed hours can be used elsewhere.
Decision rule:
- If demand for A can absorb 5,000 extra hours, redeploying them earns up to 5,000 × $40 = $200,000 contribution, and closure is strongly justified.
- If A's demand is capped, closure destroys $50,000 of contribution and the board should retain B while seeking higher-yield work.
Further information required: maximum market demand for A; whether any fixed costs are genuinely avoidable on closure (e.g. a dedicated supervisor or B-specific machine lease); alternative uses of the freed capacity; whether B's low yield per hour reflects an outdated price that could be raised; and the reliability of the machine-hour records.
3. Identify the deficiencies in the report as a piece of management information and explain the consequences of each.
Read the worked answer
- Accuracy - overheads apportioned on a basis contrary to stated policy. Consequence: product costs are wrong by $12,000 each and a strategic closure decision could be taken on distorted data.
- Relevance - absorption profit is presented for what is a short-term capacity decision; contribution per limiting factor is the decision-relevant figure. Consequence: the report invites the wrong conclusion (close B) instead of the right question (is A's demand expandable?).
- Timeliness - twelve days after month end, with no commentary, so it arrived after the operations meeting had set next month's schedule. Consequence: managers act on stale data or ignore reporting altogether.
- Presentation/interpretation - no explanation of the basis, no comparatives, no narrative, and it was circulated by a director with a conclusion attached. Consequence: the board anchors on the 'loss' and the preparer's assumptions are never challenged. A short basis note and a contribution statement alongside would have prevented this.