Choosing a Cost Driver for a Low-Volume Product
A furniture manufacturer produces two lines: standard desks (40,000 units) and custom desks (2,000 units). Total manufacturing overhead is $900,000. Under a single plant-wide rate based on direct labour hours, the custom line is allocated $60,000 of overhead. An activity-based costing (ABC) study finds: machine setups $300,000 (custom uses 900 of 1,000 setups); special inspections $200,000 (custom uses 1,800 of 2,000 inspections); general factory costs $400,000 (allocated on labour hours). The custom line currently shows a reported profit of $18,000 on revenue of $520,000. Management is deciding whether to discontinue the custom line, which is the only line using the specialised setup and inspection resources.
1. Recompute the custom line's overhead under ABC and the resulting profit.
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ABC allocation to custom line:
- Setups: $300,000 × 900/1,000 = $270,000
- Inspections: $200,000 × 1,800/2,000 = $180,000
- General costs: $400,000 × (custom labour share). If the plant-wide rate gave $60,000 total, the custom share is 60,000/900,000 = 6.67%, so general = $400,000 × 6.67% ≈ $26,667.
- Total ABC overhead ≈ $476,667
Profit: Revenue $520,000 − ABC overhead $476,667 − direct costs. Direct costs under the old method = revenue − old overhead − profit = 520,000 − 60,000 − 18,000 = $442,000. So ABC profit = 520,000 − 476,667 − 442,000 = −$398,667 (a loss).
The custom line is far less profitable than reported; the single rate cross-subsidised it.
2. Advise management whether to discontinue the custom line, and identify what additional information is needed.
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Do not discontinue on the ABC loss alone. ABC shows the custom line consumes disproportionate setup and inspection resources, but the decision hinges on avoidability and strategic effects:
- Are the $450,000 of setup and inspection costs avoidable if the line closes? If the resources are committed, the loss is not eliminated.
- Would dropping custom desks lose standard-line customers who buy both, or damage brand positioning?
- Can the price be raised, or setups reduced through batch sizing?
The ABC result is a signal to reprice or redesign, not an automatic exit decision. Relevant costing (avoidable costs, lost contribution, opportunity cost of freed capacity) should drive the final call. If setup and inspection costs are truly avoidable and no strategic loss occurs, discontinuation may be justified; otherwise retain and reprice.