COMPREHENSIVE CASE 1
Chapters 2–4
CableTech Bell Corporation (CTB) operates in the telecommunications industry. CTB has two divisions: the Phone Division and the Cable Service Division. The Phone Division manufactures telephones in a large plant in Ohio. The product lines run from relatively inexpensive touch-tone wall and desk phones to expensive, high quality cellular phones. CTB also operates a cable TV service in Ohio. The Cable Service Division offers three products: a basic package with 25 channels; an enhanced package which is the basic package plus 15 additional channels and two movie channels; and a premium package which is the basic package plus 25 additional channels and three movie channels.
The Cable Service Division reported the following activity for the month of March:
BasicEnhancedPremium
Sales (units) 50,000 500,000 300,000
Price per unit $16 $30 $40
Unit costs:
Directly attributable $3 $5$7
Driver traced $2 $4 $6
Allocated $10 $13 $15
The unit costs are divided as follows: 70 percent production and 30 percent marketing and customer service. Direct labor cost is the only driver used for tracing. Typically, the division uses only production costs to define unit costs. The preceding unit product cost information was provided at the request of the marketing manager and was the result of a special study.
Bryce Youngers, the president of CTB, is reasonably satisfied with the performance of the Cable Service Division. March’s performance is fairly typical of what has been happening over the past two years. The Phone Division, however, is another matter. Its overall profit performance has been declining. Two years ago, income before income taxes had been about 25 percent of sales. March’s dismal performance was also typical for what has been happening this year and is expected to continue—unless some action by management is taken to reverse the trend. During March, the phone division reported the following results:
Inventories:
Materials, March 1 $23,000
Materials, March 31 40,000
Work in process, March 1 130,000
Work in process, March 31 45,000
Finished goods, March 1 480,000
Finished goods, March 31 375,000
Costs:
Direct labor $117,000
Plant and equipment depreciation50,000
Material handling 85,000
Inspections 60,000
Scheduling 30,000
Power 30,000
Plant supervision 12,000
Manufacturing engineering 21,000
Sales commissions 120,000
Salary, sales supervisor 10,000
Supplies 17,000
Warranty work 40,000
Rework 30,000
During March, the Phone Division purchased materials totaling $312,000. There are no significant inventories of supplies (beginning or ending). Supplies are accounted for separately from materials. CTB’s Phone Division had sales totaling $1,170,000 for March.
Based on March’s results, Bryce decided to meet with three of the Phone Division’s managers; Kim Breashears, divisional manager; Jacob Carder, divisional controller; and Larry Hartley, sales manager. A transcript of their recorded conversation is given next:
Bryce: “March’s profit performance is down once again, and I think we need to see if we can identify the problem and correct it—before it’s too late. Kim, what’s your assessment of the situation?”
Kim: “Foreign competition is eating us alive. They are coming in with lower-priced phones of comparable or higher quality than our own. I’ve talked with several of the retailers that carry our lines, and they say the same. They are convinced that we can sell more if we lower our prices.”
Larry: “They’re right. If we could lower our prices by 10 to 15 percent, I think that we’d regain most of our lost market share. But we also need to make sure that the quality of our products meets that of our competitors. As you know, we are spending a lot of money each month on rework and warranties. That worries me. I’d like to see that warranty cost cut by 70 to 80 percent. If we could do that, then customers would be more satisfied with our products, and I bet that we would not only regain our market share but increase it.”
Jacob: “Lowering prices without lowering per-unit costs will not help us increase our profitability. I think we need to improve our cost accounting system. I am not confident that we really know how much each of our product lines is costing us. It may be that we are overpricing some of our units because we are overcosting them. We may be underpricing other units.”
Larry: “This sounds promising—especially if the overcosting is for some of our high-volume lines. A price decrease for these products would make the biggest difference—and if we knew they were overcosted, then we could offer immediate price reductions.”
Bryce: “Jacob, I need more explanation. We have been using the same cost accounting system for the last 10 years. Why would it be a problem?”
Jacob: “I think that our manufacturing environment has changed. Over the years, we have added a lot of different product lines. Some of these products make very different demands on our manufacturing overhead resources. We trace—or attempt to trace—overhead costs to the different products using direct labor cost, a unit-based cost driver. We may be doing more allocation than tracing. If so, then we probably don’t have a very good idea of our actual product costs. Also, as you know, with the way computer technology has changed over time, it is easier and cheaper to collect and use detailed information—information that will allow us to assign costs more accurately.”
Bryce: “This may be something we should explore. Jacob, what do you suggest?”
Jacob: “If we want more accurate product costs and if we really want to get in the cost reduction business, then we need to understand how costs behave. In particular, we need to understand activity cost behavior. Knowing what activities we perform, why we perform them, and how well we perform them will help us identify areas for improvement. We also need to know how the different products consume activity resources. What this boils down to is the need to use an activity-based management system. But before we jump into this, we need some idea of whether nonunit-based drivers add anything. Activity-based management is not an inexpensive undertaking. So I suggest that we do a preliminary study to see if direct labor cost is adequate for tracing. If not, then maybe some nonunit-drivers might be needed. In fact, if you would like, I can gather some data that will provide some evidence on the usefulness of the activity-based approach.”
Bryce: “What do you think, Kim? It’s your division.”
Kim: “What Jacob has said sounds promising. I think he should pursue it and do so quickly. I also think that we need to look at improving our quality. It sounds like we have a problem there. If quality could be improved, then our costs will drop. I’ll talk to our quality people. Jacob, in the meantime, find out for us if moving to an activity-based system is the way to go. How much time do you need?”
Jacob: “I have already been gathering data. I could probably have a report within two weeks.”
MEMO
TO:Kim Breashears
FROM:Jacob Carder
SUBJECT: Preliminary Analysis
Based on my initial analysis, I am confident that an ABC system will offer significant improvement. I regressed total monthly overhead cost on monthly direct labor cost using the following 15 months of data:
OverheadDirect Labor Cost
$360,000 $110,000
300,000 100,000
350,000 90,000
400,000 100,000
320,000 90,000
380,000 100,000
300,000 90,000
280,000 90,000
340,000 95,000
410,000 115,000
375,000 100,000
360,000 85,000
340,000 85,000
330,000 90,000
300,000 80,000
The results were revealing. Although direct labor cost appears to be a driver of overhead cost, it really doesn’t explain a lot of the variation. I then searched for other drivers—particularly nonunit drivers—that might offer more insight into overhead cost behavior. Every time a batch is produced, material movement occurs, regardless of the size of the batch. The number of moves seemed like a more logical driver. I was able to gather only 10 months of data for this. (Our information system doesn’t provide the number of moves, so I had to build the data set by interviewing production personnel.) This information is provided next:
Material-Handling Cost Number of Moves
$80,000 1,500
60,000 1,000
70,000 1,250
72,000 1,300
65,000 1,100
85,000 1,700
67,000 1,200
73,500 1,350
83,000 1,400
84,000 1,700
The regression results were impressive. There is no question in my mind that the number of moves is a good driver of material-handling costs. Using the number of moves to assign material-handling costs to products would likely be better than the cost assignment using direct labor cost. Furthermore, since small batches use the same number of moves as large batches, we have some evidence that we may be overcosting our high-volume products.
I looked at one more overhead activity: inspecting products. We have 15 inspectors who are paid an average of $4,000 per month. Each inspector offers about 160 hours of inspection capacity per month. However, it appears that they actually work only about 80 percent of those hours. The drop in demand we have experienced explains this idle time. I see no evidence of variable cost behavior here. I’m not exactly sure how to treat inspection cost, but I think that it is more related to inspection hours than direct labor cost. Some of the other overhead activities seem to be nonunit-level, as well—enough, in fact, to be concerned about how we assign costs.
Required:
- Compute two different unit costs for each of the Cable Service Division’s products. What managerial objectives are being served by these unit cost computations?
- Three different cost categories are provided by the Cable Service Division: direct attribution, driver tracing, and allocation. Discuss the meaning of each. Based on how costs are assigned, do you think that the Cable Service Division is using a functional-based or an activity-based cost accounting system? What other differences exist between functional-based and activity-based cost accounting systems?
3.Discuss the differences between the Cable Service Division’s products and the Phone Division’s products.
- Prepare an income statement for the Cable Service Division for March.
- Prepare an income statement for the Phone Division for March. Include a supporting cost of goods manufactured statement.
- The Phone Division has been using the same cost accounting system for over 10 years. Explain why its cost accounting system may be outmoded. What factors determine when a new cost accounting system is warranted?
- Using the method of least squares, calculate two cost formulas: one for overhead using direct labor cost as the driver, and one for material-handling cost using number of moves as the driver. Comment on Jacob Carder’s observations concerning the outcomes.
8.How would you describe the cost behavior of the inspection activity? Assume that the quality control manager implements a program that reduces the number of defective units by 50 percent. Because of the improved quality, the demand for inspection hours will also drop by 50 percent. What is the potential monthly reduction in inspection costs? How did knowledge of inspection’s cost behavior help?
COMPREHENSIVE CASE 3
chapters 11–16
Zando Pharmaceuticals is an affiliate of the German-based Heisenberg Corporation, which employs 40,000 worldwide. Zando’s St. Louis facility houses the U.S. corporate headquarters and Research and Development. It produces 30 products, using 28 different batch processes. The facility has 2,000 employees on-site. In recent years, Zando’s profitability has suffered, which can be attributed to increased competition, customer dissatisfaction, and regulatory pressures. Luis Alvarado, president of Zando, called a meeting to consider ways to improve profitability. He labeled the meeting a strategic planning session and invited the following officers: Kathy Shorts, environmental manager, Troy Lewis, head of R&D, Johnny Mizukawa, vice president of production and quality, Larry Sower, vice president of finance, and Doreen Savara, marketing vice president.
Luis: “You all have received the quarterly financial reports for the last two years. The trends are negative. We are losing market share, profits are decreasing, and our costs seem to be increasing. We need to take actions to increase sales and reduce costs, and we need to do so as quickly as possible. Given our research strengths, it seems to me that our best bet is to grow revenues by introducing new products with proprietary rights. As far as costs are concerned, we need to improve our performance on that dimension as well. Lower per-unit costs for new and existing products are needed. Any suggestions?”
Troy: “For our products, our ability to control costs resides in development—my area—rather than manufacturing. We probably need to pay more attention to product and process design issues to ensure a reasonably level per-unit cost. Revenues are also affected in this stage. Once we patent a drug, the clock begins to tick, and we need to reduce time to market. Significantly, reducing time to market will allow us to generate revenues for a longer period of time than we are currently experiencing. It would also be helpful if we could reduce the cycle time for product development. Both actions would increase revenues. Finally, we can increase revenues by increasing the volume of new products.”
Johnny: “There is a lot of merit to the observation that cost reduction opportunities reside mostly in product development. Once a drug is approved, its approval includes the manufacturing process. Any future changes in the manufacturing process require approval from the U. S. Food and Drug Administration. Because of this, we have been reluctant, historically, to engage in process improvement or reengineering. However, I wonder if we shouldn’t reconsider this longstanding policy. Some of the quality problems we have could be corrected by changing some of our existing processes, and the costs saved may easily exceed any cost incurred from seeking FDA approval. I think our quality costs are at least 15 percent of sales. That’s a lot of opportunity for improvement.”
Kathy: “I agree that cost reduction—both in the product development stage and the manufacturing stage—should be a key strategic theme. The environmental area also offers some very good opportunities. A recent pollution prevention act passed by the legislature requires that we calculate the costs of generating hazardous substances for each process. This act was the incentive we needed to begin developing an environmental cost management system. The results so far indicate that environmental costs are much more than we realized. They are estimated to be in the range of 20 to 30 percent of total operating costs. Environmental costs can be reduced by such things as computerizing chemical inventory, eliminating the use of chlorinated solvents and other hazardous materials, reducing our use of virgin feedstocks, and redesigning processes and products so that we can reduce toxic residue release. We can really have a positive environmental impact while simultaneously reducing costs if more attention is paid to environmental issues during product development.”
Doreen: “I like what I am hearing because I think that it also affects our ability to increase market share and revenues. For example, environmental impact is one of our major concerns. Some retail pharmacy chains pay particular attention to green products, and right now we are not competing well. Our environmental image is negative and needs to be improved. I am convinced that doing so will allow us to increase market share. Quality is another important matter. We have had to recall two batches of products during the past two years due to poor quality, and this has hurt our image more than the environmental issue. Improving the processes to avoid these kinds of problems will save us a lot of grief. Product image and reputation are essential to increasing customer satisfaction and market share.”
Luis: “We started with the need to improve financial performance by increasing revenues and reducing costs. So far, we have some very good suggestions to help achieve these two objectives, but I have some concerns. First, do we have the talent and capabilities to improve quality and environmental performance? Troy, do your professionals really understand what they need to do to improve process and product designs so that we can see the desired quality and environmental improvements? Also, how can we reduce the cycle time for products and the time to market once patented?”
Troy: “Let me answer those question in order. First, we probably are lacking the understanding on the design issues. We will need to do some training to help our research scientists and chemical engineers understand the consequences. We may need to hire a couple of professionals who have experience in dealing with these issues. Second, we may need to make cycle time and time to market significant performance measures and reward our people for actions that reduce those measures. Our employees need to align their interests with those of the company. If we can achieve this, we should see more revenue produced per employee.”
Luis: “Good. Now, Johnny, tell us about production and quality. Do our manufacturing engineers and production workers need help with environmental and quality issues?”
Johnny: “Without question, training will be needed. Moreover, I really need to hire a couple of quality engineers.”