CCE Unitron Corporation reba rare | This case is set in 1974 in a Boston-based “hi-tech” firm which was a pioneer in the “‘solld state” electronic components that were the basis for “third generation" computers and were the early prototypes for modern integrated circuits. The basic issua is the classic “Joint cost” dilemma, In 1974, Unitron Corporation was only 20 years old, but it had already succeeded in positioning itself as a respected producer of high-quality electronic components. Included among the firm's product lines were rectifiers, thyristors, zeners, diodes, and other high-voltage assemblies. These products represent fundamental electronic components in such fields as minicomputers, process controllers, defense systems, and communications equipment. With sales of $30 million, Unitron was clearly such smaller than the component industry's “Big Three” of Texas Instruments, Fairchild, and Motorola. However, by concentrating on high performance in selected high-quality segments of the market, Unitron had developed into the market leader in many specialty components. This gave the firm a competitive advantage that permitted them to maintain a price-leadership position within these segments, Rectifiers were a significant product group for Unitron. A rectifier’s function is to allow electrical current to pass in one direction while preventing movement in the reverse direction. Its action therefore is similar to that of a valve in fluid mechanics. Exhibit 1 shows the steps in producing a completed rectifier unit which is about 1/2 the size of a cigarette. The value of this product to the final user is primarily determined by two characteristics; the rapidity of response in blocking current reversals and the “surge capacity” or maximum voltage level the rectifier can withstand, Unfortunately, for all manufacturers including Unitron, there is no known method of controlling production procedures to obtain exact electrical characteristics. Each production batch differs from ‘other batches processed under ostensibly the same conditions. Furthermore, within each batch, the individual units do not have precisely the same characteristics. Over many production runs, the distribution of unit characteristics closely resembles a standard “bell curve.” ‘The production process starts by placing a batch of $0 silicon wafers (purchased from outside suppliers) in a furnace heated to 1,200°C and containing specially prepared metallic gas impurities. By altering the concentration of the impurities, different electrical characteristics can be induced in the ‘wafers, However, an improvement in one characteristic is often accompanied by a decline in another. Also, in spite of strict monitoring of the furnace conditions, small differences in temperature and gas, distribution do occur and these variations alter the final products. ‘Upon leaving the furnace, each wafer if cut into about 2,000 silicon chips, each approximately the size of a ball-point pen tip. Exhibit 1 illustrates the production sequence then followed. First a chip is fused between two metal cylinders making a “sandwich.” In Step 2 this “chip sandwich" is, enveloped in a glass sleeve. In Step 3 this sleeve is heated while in place, forming a molecular bond with the silicon chip, Silver or copper wires are then attached in Step 4, In Step 5, the finished product, is painted according to a color code. ‘The wafers and chips are tested at each step during production for physical and electrical defects. About 60% of the 100,000 chips in s batch reach the end of Step 3. Of that percentage, only one-third or less are eventually sold as part of the regular product line. Another 5,000 units at the lower end of the distribution have limited marketability and are not repairable. Although Unitron did not consider these items to be part of the regular product line, they were offered for sale as “seconds” for use as components in relatively inexpensive and usually disposable items such as toys or small hhome appliances. No marketing effort was devoted to these “by-product” units, The overall manufacturing process in summarized in Exhibit 2.256 Production cost data relating to the rectifier series is reproduced below: Product Cost Data for 400 Series Rectifiers Annual Costs Batch Costs Direct Materials $2,500 Direct Labor 1,600 Variable Overhead 2,300 Total $6,400 x20! $128,000 Nonvariable Rectifier ‘Manufacturing Costs? 32,000 General Factory Overhead Costs? 49,000 Total Manufacturing Cost ‘$200,000 1 Production of 400 Series rectifiers was running at about 20 batches per year. 2. Allocated to 400 Series rectifiers based on direct labor cost. ACCOUNTING - THE JOINT COST PROBLEM ‘Whenever production costs are not directly assignable to specific units, cost accounting systems rely on allocation Tules to assign the costs to the units, Direct material cost, for example, is usually directly identifiable with individual units. But, equipment depreciation must somehow be allocated to the units produced on that ‘equipment. A “fully allocated cost per unit” is deemed necessary by most companies for purposes of valuing inventory and to create a cost base for use in managerial decision making. ‘The manufacturing of the silicon “sandwich” by ‘Unitron creates components with differing electrical characteristics and therefore differing sales value, but the ‘manufacturing costs are “joint” with respect to the batch. In other words, there is no way to specifically match any of the costs with any of the individual components produced in one batch. All that can be said is that certain costs are incurred to produce a batch which contains rectifiers with varying electrical characteristics, ‘There are two common techniques used for allocating such joint costs. The first method is to divide all joint costs by the tots! number of salable units produced during the process, This method is often called the “average” or “physical unit” approach, It normally yields a different gross margin percentage for each end product since the allocated costs per unit are equal regardless of the sales value per unit, ‘A. second widely used joint costalfocation Unitron Corporation method is called the “relative sales value” approach, It assigns costs to units based on each unit's pro-rata share of the total market value of all units produced. For example, if products A, B, and C cost $800 to produce, jointly, and have sales values of $500, $300, and $200, ‘respectively, the allocation of costs to produce B is 30% (30/1000) of $800, or $240. When this method is used, the gross margin percentage for all products is always the same. Exhibit 3 shows some common examples of the Joint cost problem and a more detailed example of the two main methods of accounting for joint costs. THE BUSINESS PROBLEMS Exhibit 4 lists sales prices and present inventory levels for the 400 series rectifiers, along with projected annual sales and production, The breakdown of products per batch remains fairly constant from batch to batch. Helen Barnes, a recent MBA graduate, was just beginning a 6 month training assignment as assistant to Unitron’s sales manager, Jim Jacoby. He called her attention one moming to an order for 6,000 units of series 401 rectifiers which had just been received. While many of the product lines were not inventoried, rectifiers normally were, However, very few of the 401 units were currently available in inventory. To satisfy the customer's needs, the order had to be filled with units that met or exceeded the specifications of the product ordered. The customer was perfectly willing to accept rectifiers whose performance characteristics exceeded the minimum specified levels; however, the customer was not willing to pay for the extra quality. Jim Jacoby asked Helen which would be better for Unitron: 1, to fill out the order with 402 rectifiers, 2. to trigger a production run in order to be able to fill the order with 4015, 3. to tum down the order because of the “out of stock” condition. If additional production were authorized, inventory levels of other units would obviously go up. Jacoby was concemed about this because his performance was evaluated partly in terms of the profits generated by the rectifier lines after deducting a charge for inventory carrying cost. Besides the chance of inventoried rectifiers becoming obsolete in the marketplace, the higher level of inventory would tie up more cash. Jacoby was charged camying costs of 2% a month on all inventory. He liked to Keep inventory at no more than one month's sales, ‘because he thought a tumover ratio of 12 times was a- Unitron Corporation good compromise between stockout risk and excess investment. After discussing this order, Jacoby also asked Bames for her opinion about an offer which had recently been received from a local toy company to purchase 4,000 of the Series 400 “seconds” units each month at a price of $.15 per unit, The toy company was willing to sign a firm contract calling for 48,000 units during the next year. Jacoby said the production manager was against accepting this business at what he called a “giveaway price.” He hhad said that §.15 wouldn’t even cover the out-of-pocket ‘expenses of S.32 per unit and that no one in their right mind would tie themselves down to a long-run contract at a price which didn't even cover the variable costs. Jacoby, however, was bothered by the growing accumulation of inventory of the seconds, even though they were carried at zero inventory value (see Exhibit 4), He asked Helen whether she agreed with the production manager that he was being naive to think of the $.15 as pure profit just because of the zero inventory value assigned {o these units by the cost accounting department, ‘Another problem Jacoby was considering involved a one-time Defense Department request for bids ‘on 100,000 units of the 404 Series rectifiers. The request asked for a “cost plus” bid, but Jim was not sure what “cost” was. He felt sure the government was expecting bids at something less than Unitron’s list price of $.80 per unit, Probably, $.75 was close to what the govemment ‘was expecting to pay, per unit. Delivery was to be scheduled over eighteen months, at about 5500 units per month. Unitron did not want to be too heavily dependent on government business and had worked hard to bring the mix of business up to 75% commercial/ 25% government in 1974, But this bid was for work on a prestigious new defense system which could be good for Unitron’s reputation, if costs and prices could be worked out, 27 QUESTIONS 1. Ina period which began with zero inventories, how should Unitron assign the production ourput (400,000 units) of 20 batches to the sales orders (400,000 units)? The idea here is to construct a “produced as/sold as” matrix. 2, Compute the per unit costs for rectifiers in the 400 series under an average costing system and under a relative sales value system, 3. A. What would be the revenue, cost, and profit if the order for 6000 401's were accepted for immediate shipment: — under a physical unit costing system — under a relative sales value costing system, B. What should Helen Bames recommend to Jim Jacoby regarding this order? Why? 4, What should she recommend regarding the offer from the toy company? 5. Which method of allocating joint costs should Unitron use? Which method yields better data for decision-making? Consider the behavioral implications of the two different approaches. 6. A government purchasing agent has just inquired again about the “cost plus” purchase contract for 100,000 404’. The contracting official had stated that 9 10% profit margin would probably be allowable, if the price were “right” ($.75, or so). ‘How much is the “cost?” What are your thoughts about price and manufacturing strategy for this possible contract? Assuming excess manufacturing capacity is available, would you recommend bidding on this contract? If so, at what price? =. 258, Unitron Corporation EXHIBIT 1 The Chip oF] 0 Lt ow ne) ges, () } J+ "Sandwich" Step 2 ———} im seep Cc Step 4 oa (| Step 5 Color Coded PaintUnitron 259 EXHIBIT 2 The Manufacturing Process Purchased Raw Material (50 Silicon Wafers) ——— Bake at 1200° C with Special Gasses —e Cut into 100,000 Very Small Chips v -Manufacture a "Chip Sandwich” (Lose 40,000 Chips in Manufcturing) v Test 60,000 Chips for Electrical Characteristics (There is a Random Distribution of Product Specifications) On Average t+ 4 Iq By-Products Sorap ("Seconds") Regular Product Line 35,000 Units 5,000 Units 20,000 Units ofseries #400 4,402 _403__404_ _405 4500 000 4500 “3000 "2000| 260. Unitron Corporation 1e Joint Cost All manufacturing (or service) costs apply jointly to all ofthe products (services). There is no way to specifically identify costs with each specific product (service). Examples Oil Refinery (Gasoline/ Diesel’ Heating oil/ Jet Fuel) Railroads or Airlines (Passengers/ Freight/ Mail) Postal Service (Home mail Bulk mail/ Packages) Slaughterhouse (Steak/ Roasts/ Hamburger) Mining (High grade ore/ Low grade ore) Batch Process Electronic Components ‘Two Major Accounting Methods 1, Physical Unit Approach 2. Relative Sales Value Approach A Simplo Example (Butchering a Cow) Joint Costs: ‘The Cow $580 Labor Cost $160 (8 hours x $20/hour) Depreciation on the butcher knife ‘& table $10 Total Cost $750 Meat Produced = 300 pounds of hamburger (which sells for $2.00/1b.) 200 pounds of steak (which sells for $4.50/Ib.) ‘500 pounds ($1500 sales value) Physical Unit Approach Cost Per Pound Cost = $750 Steak ‘Hamburger ‘Meat produced = 500 pounds Costipound (for all meat) $1.50 $1.50 Profit/pound (% of Sales) $3.00 67%) .50 (25%) Relative Sales Value Approach % of sales value Tay = 60% a 40% Cost allocation (60% x $750 = $450 40% x 750 = $300 Cost per pound Sa =$2.25 $32. s1.00 Profit per pound (% of Sales) 2.25 (50%) 1,00 (50%)+ Unitron 261 ‘EXHIBIT 4 Series 400 Rectifiers Maximum ‘Annual Current ‘Annual Voltage Sales Orders Inventory Production Product Blockage (volts) units) Sales Price/Unit funits). (units) 401 25-74 300 100,000 $40 3,000 90,000 402 75-124 400 140,000 60 10,000 120,000 403 1,.25-1.74 500 100,000 70 9,000 90,000 404 1,75-2.24 600 40,000, 80 8,000 60,000 405 2.25-2.75 700 20,000 1.00 §,000 40,000 300,000 35,000 490,000 ‘A typical batch also yields 5,000 of the lower-quality “by-product” units which Unitron offered for sales as “seconds.” Demand for the “seconds” fluctuated widely and was very price-sensitive. Unitron offered these units at a price of $.25 ‘each, but sales had been very slow during the past year. An inventory of 65,000 units had accumulated. By-products like these units were not considered to be part of the regular product line, and were not assigned an inventory value. ‘Whatever revenue they generated was considered miscellaneous income and was offset against cost of goods sold for financial statement purposes,