Customer Profitability and a Capacity-Constrained Special Order
Crestview Components Inc. produces precision parts and uses a traditional costing system that allocates $1,200,000 of manufacturing overhead to products on the basis of machine hours. Budgeted machine hours are 60,000, giving a rate of $20 per machine hour. Two customers account for most of the plant's work. Customer A generated $2,400,000 of revenue, $800,000 of direct materials, $300,000 of direct labour, and used 30,000 machine hours, 200 purchase orders, 1,200 inspections, and 40 setups. Customer B generated $1,600,000 of revenue, $600,000 of direct materials, $150,000 of direct labour, and used 12,000 machine hours, 20 purchase orders, 200 inspections, and 5 setups. An activity analysis shows overhead of $600,000 for machining (60,000 machine hours), $240,000 for order processing (220 orders), $240,000 for inspections (1,400 inspections), and $120,000 for setups (45 setups). Crestview has capacity for 60,000 machine hours and currently uses 42,000. A new customer, C, offers $450,000 for an order that would use 4,000 machine hours, $320,000 of direct materials, $80,000 of direct labour, 10 orders, 50 inspections, and 2 setups. C's order would not affect existing customers.
1. Compare customer profitability for A and B under traditional costing and activity-based costing. Show calculations and interpret the results.
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Traditional costing
Overhead rate = $1,200,000 / 60,000 MH = $20 per MH. Customer A:
- Revenue $2,400,000 - DM $800,000 - DL $300,000 - OH (30,000 x $20 = $600,000) = $700,000 profit. Margin 29.2%. Customer B:
- Revenue $1,600,000 - DM $600,000 - DL $150,000 - OH (12,000 x $20 = $240,000) = $610,000 profit. Margin 38.1%. Traditional costing suggests A is more profitable in absolute dollars.
Activity-based costing
Rates:
- Machining: $600,000 / 60,000 = $10 per MH
- Order processing: $240,000 / 220 = $1,090.91 per order
- Inspections: $240,000 / 1,400 = $171.43 per inspection
- Setups: $120,000 / 45 = $2,666.67 per setup
Customer A overhead:
- Machining: 30,000 x $10 = $300,000
- Orders: 200 x $1,090.91 = $218,182
- Inspections: 1,200 x $171.43 = $205,714
- Setups: 40 x $2,666.67 = $106,667 Total = $830,563. Profit = $2,400,000 - $800,000 - $300,000 - $830,563 = $469,437. Margin 19.6%.
Customer B overhead:
- Machining: 12,000 x $10 = $120,000
- Orders: 20 x $1,090.91 = $21,818
- Inspections: 200 x $171.43 = $34,286
- Setups: 5 x $2,666.67 = $13,333 Total = $189,437. Profit = $1,600,000 - $600,000 - $150,000 - $189,437 = $660,563. Margin 41.3%.
Interpretation
ABC reverses the ranking: B is more profitable than A. A consumes 91% of orders, 86% of inspections, and 89% of setups while generating 60% of revenue. A's high cost-to-serve is hidden by the machine-hour allocation. Management should not drop A automatically, because it may absorb fixed capacity and contribute to overhead, but it should reprice A, impose minimum order sizes or inspection fees, and reduce A's complexity.
2. Evaluate whether Crestview should accept C's special order using relevant costing and the ABC information.
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Relevant costing for C
Incremental revenue = $450,000. Incremental direct materials = $320,000. Incremental direct labour = $80,000. Incremental ABC-driven overhead: order processing 10 x $1,090.91 = $10,909; inspections 50 x $171.43 = $8,571; setups 2 x $2,666.67 = $5,333; total = $24,813. Machining overhead: Crestview has 18,000 MH of idle capacity, and C needs 4,000 MH. If the $600,000 machining overhead is fixed within the relevant range and no additional machine or supervisor is needed, it is not an incremental cost. If the order would trigger a step cost, include it. Incremental cost = $320,000 + $80,000 + $24,813 = $424,813. Incremental profit = $25,187. If order processing, inspection, and setup resources are also fixed and not increased, the incremental profit is $50,000.
Decision
Accept C only if:
- the 4,000 MH cannot be sold to another customer at a better contribution;
- the $24,813 of activity costs are truly incremental or the resources are idle;
- C will not expect the $450,000 price or the low-complexity terms in future orders;
- the order does not cannibalize A or B or violate capacity, quality, or labour constraints. A full ABC cost of C would allocate $40,000 of machining overhead and show a loss of about $14,813. That is not the relevant decision cost if capacity is idle. The order is marginally profitable, so accept it with a time-limited, capacity-contingent pricing structure.
3. What pricing or customer-mix actions would you recommend based on the ABC results?
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Pricing and customer mix
- Increase prices for A or move A to a menu that charges separately for orders, inspections, and expedited setups. A's 200 orders and 1,200 inspections are the main drivers of its low margin.
- Offer B volume discounts or priority capacity, because B earns $660,563 on $1.6 million of revenue with much lower complexity.
- Set minimum order quantities and a standard inspection allowance; charge for inspections beyond the allowance.
- Track cost-to-serve by customer, not just gross margin, and report it monthly to sales and operations.
- Before dropping A, test whether its contribution after avoidable costs still covers fixed overhead. If A is retained, use it to fill capacity but do not let it consume constrained inspection or setup time without a surcharge.
- For C, use a special-order price with a capacity clause and a requirement that the order be placed in off-peak periods.