Molvar: Activity-Based Costing Reveals a Cross-Subsidy - and a Bad Drop Decision
Molvar makes two products. Total manufacturing overhead is $1,200,000, currently applied on machine hours: Standard uses 120,000 hours (60,000 units × 2 hours), Custom uses 60,000 hours (10,000 units × 6 hours). A consultant proposes three pools: setup $300,000 (200 setups: 50 Standard, 150 Custom); machine-related $600,000 (on machine hours); engineering and inspection $300,000 (3,000 engineering hours: 1,000 Standard, 2,000 Custom). Direct costs are $95 per Standard unit and $180 per Custom unit. Standard sells for $120; Custom sells for $250. The sales VP wants to drop Custom, saying it "barely breaks even." Custom's dedicated setup and engineering staff cost $425,000 in total and would be released if the line were dropped; $50,000 of machine-related overhead is variable power, and the remaining $550,000 is facility depreciation and supervision that would continue.
1. Compute overhead per unit under the current system and under the proposed ABC system, and quantify the cross-subsidy.
Read the worked answer
Current (machine-hour) system - rate = $1,200,000 / 180,000 hours = $6.6667 per hour.
- Standard: 120,000 × $6.6667 = $800,000 → $13.33 per unit
- Custom: 60,000 × $6.6667 = $400,000 → $40.00 per unit
ABC
- Setup rate = $300,000 / 200 = $1,500 per setup; Engineering rate = $300,000 / 3,000 = $100 per hour; Machine rate = $600,000 / 180,000 = $3.3333 per hour.
| Pool | Standard | Custom |
|---|---|---|
| Setup | 50 × 1,500 = 75,000 | 150 × 1,500 = 225,000 |
| Machine | 120,000 × 3.3333 = 400,000 | 60,000 × 3.3333 = 200,000 |
| Engineering | 1,000 × 100 = 100,000 | 2,000 × 100 = 200,000 |
| Total | 575,000 | 625,000 |
| Per unit | $9.58 | $62.50 |
Cross-subsidy: Standard is overcosted by $13.33 − $9.58 = $3.75 per unit (60,000 × $3.75 = $225,000); Custom is undercosted by $62.50 − $40.00 = $22.50 per unit (10,000 × $22.50 = $225,000). The two offset exactly. Cause: Custom consumes 3× the machine hours and 3× the setups and 2× the engineering hours per unit, but the single driver only captures machine time.
2. Compute Custom's full unit cost and margin under each system. Which cost should the pricing team act on, and what must be verified before repricing?
Read the worked answer
Custom, per unit
- Traditional: $180 + $40.00 = $220.00 → margin $30.00 = 12.0% of price
- ABC: $180 + $62.50 = $242.50 → margin $7.50 = 3.0% of price
Standard, per unit
- Traditional: $95 + $13.33 = $108.33 → margin $11.67 = 9.7% of price
- ABC: $95 + $9.58 = $104.58 → margin $15.42 = 12.9% of price
The ABC number is the better decision input: it reflects the resources Custom actually consumes, and the shift in both products' apparent profitability is economically sensible - the low-volume, high-complexity line was being subsidized by the high-volume line. But ABC is still a full-absorption number and must not be used as a floor price.
Verify before repricing:
- Cost pool integrity - are the $1,500 setups and $100 engineering hours real, or is idle capacity loaded in? Use practical capacity as the denominator, or costs get inflated by unused capacity.
- Driver causality - is a setup actually driven by number of setups, or by setup hours? A long, difficult setup on Custom may justify an even higher charge.
- Competitive position - what does the market bear? A 3% margin says the price is too low, but a price increase may simply hand the business to a competitor; consider re-engineering (reducing 15 setups per 1,000 units) before repricing.
- Whether the price already reflects a strategic choice (loss leader, capacity filler).
3. Evaluate the VP's proposal to drop Custom using relevant costing. Should Molvar drop the line? State the decision rule and one qualitative factor.
Read the worked answer
Relevant-cost analysis of dropping Custom (annual).
| Item | Amount |
|---|---|
| Lost revenue (10,000 × $250) | (2,500,000) |
| Saved direct cost (10,000 × $180) | 1,800,000 |
| Lost contribution after direct costs | (700,000) |
| Saved dedicated setup and engineering staff | 425,000 |
| Saved variable power | 50,000 |
| Net effect of dropping | (225,000) |
Machine depreciation and supervision ($550,000) are not avoidable, so they are irrelevant to the decision even though ABC assigns $200,000 of them to Custom. Dropping Custom reduces company profit by $225,000.
The ABC-based "Custom earns only $7.50 a unit" figure quietly includes $62.50 of allocated cost, most of which does not disappear. That is the trap: allocated cost is not avoidable cost.
Decision rule: drop a line only when the contribution margin given up is less than the avoidable fixed and variable costs eliminated - i.e., when the segment's contribution to common costs is negative. Here it is positive.
Qualitative / strategic consideration: the 40,000 machine hours freed (60,000 hours less 20,000 if the freed capacity has no use - state the assumption clearly) could be redeployed. If that capacity can generate more than $225,000 of contribution from Standard or a new product, dropping Custom becomes correct; if it sits idle, it does not. Also consider whether Custom pulls through Standard sales with the same customers.