MANAC ASSIGNMENT – 1

Gaurav Nair – B19017

Nikhil Jindal––B19041
Sahil Gupta B19030
Ray – –B19040
SIEMENS ELECTRIC Sahil Gupta
Ronit B19041
Sahil Gupta – B19041

MOTOR WORKS
Process-Oriented Costing
Executive Summary:
Leading up to 1987, the Electric Motor Works department of Siemens invested heavily for
automation of the plant and switch to production of specialty motors on custom orders,
close to DM 50 million. As a result of which, they were able to identify the inadequacies
of their traditional costing system which was not able to accurately allocate the support
overheads, which increased drastically due to increase in number of orders along with
reduction in number of motors per order.
As a result, the company shifted to a new costing system which separately recorded and
allocated support overhead costs consisting of order processing and special component.
We recommend dividing the order processing cost on the basis of total number of orders
and special component cost on the basis of total number of special requisitions. As a result
of which, the company will be able to ascertain the cost of each order more accurately
also be able to set an optimum pricing strategy.
With the new costing method, we also find out that Siemens should frame policies to
discourage small orders and incentivize customers to order in higher quantities (10 or
more) to reduce cost per unit and maximize profits.

Problem Statement:
The Electric Motor Works department of Siemens changed their strategy from producing
standard motors to focusing on customized specialty orders. This switch highlighted the
inefficiencies of the traditional costing system.
The major issue with the traditional costing system was that it did not properly capture
the relationship between the increased support cost due to increased specialty orders
and the changed product mix. Traditionally, support costs were allocated based on sum
of Direct Material and Direct labor. But support costs related more to orders received and
customized orders rather than to materials and labor hours.
In the last year, 74% of the orders received were of less than 5 motors. The increase in
number of orders along with reduction in number of motors per order led to increased
load on the support department. The resources required to process 1 custom order of
specialty motor was equal to that of processing an order of 100 standard motors.
Alternatives available:
1. Continue with traditional method: - First alternative would be to continue with the
previous costing method. Company would continue allocating the Material Overhead on
basis of Direct Material consumed and Product Overhead on basis of either direct labor
hours or machine hours. Whereas company’s Support Overhead would be allocated
based on sum of Direct Material, Direct Labor costs, Material OH, Production OH.

2. Use the Activity based costing: - Second alternative would be to allocate Support
Overhead according to the new method being used by the company. Support Overhead
was assigned to two pools- order processing cost and special component cost. After the
division both pools are allocated according to the Activity based costing method. Rest of
the overhead cost would be allocated according to the traditional method.

3. Using Specific costing for each order: - This alternative deals with a more direct method
of costing taking each order as a reference to implement the cost calculations. The
different specific cost elements are taken into consideration and dealt with separately
with each order. Individual costs of each element in the final product are added in respect
to the actual usage and rate of each of the cost component.

Criteria for evaluating alternatives:

In order to rate each of our alternatives we have identified the following parameters like
cost estimation accuracy, feasibility of implementation and reliability of the costing
method. These parameters are then weighed amongst each other to analyze and suggest
the best possible alternative which would not only provide the most appropriate selling
cost of the products but also is both feasible and reliable in the long run.
The third alternative of specific costing for each order would provide the most accurate
selling price approximations but the feasibility of this method is very low. This type of
costing gets more difficult with the increase in order complexity and is not recommended
as calculating and allocating the costs of support activities (order processing and special
components) to each specific order is a tedious process.
The first alternative of continuing the already existing traditional costing process does not
capture the relationship between the increased cost of support activities due to a rise in
specialty orders. This is because these support costs are linked to the customized orders
rather than direct materials and labor hours.
Exhibit 1: Comparing Total Cost in Old and New System
Old System New System
Direct Materials 105000.00 105000.00
Material Overheads 6000.00 6000.00
Direct Labor 36000.00 36000.00
Production Overheads120000.00 120000.00

Engineering 12000.00 5700.00

Tooling 22500.00 22500.00
Administrative Expenses60000.00 33000.00

Order Processing 0.00 13800.00

Special Component 0.00 19500.00

TOTAL 361500.00 361500.00

Amounts in '000

Most Probable solution:

The second alternative of using activity-based costing rates the highest in all the 3
parameters since it is an optimum allocation of overheads with the minimum efforts to
set the appropriate selling price.
Exhibit 2: Calculating Cost Driver & Cost Driver rate per unit/order
Total Cost ( '000) Basis Rate per unit
Special Component 19500 Special requisitions 325000 60
Order Processing 13800 Total orders 65625 210.29

For calculating the five orders under the new system, we must first calculate the cost of
order processing and special components is calculated using cost of each divided by the
cost driver (basis). Special components cost is driven by the number of times processed
and the cost of order processing is driven by the number of orders. This calculation shows
that the cost per special order processed is $60.00 and the cost of each order processed
is $210.29.
Exhibit 3: Cost per order under New System
New System of Costing
Order A B C D
E
Direct Costs:
Base Motor 304.00 304.00 304.00 304.00 304.00
Specialty Motor 39.60 79.20 118.80 198.00 396.00
Overheads:
Special component 60.00 120.00 180.00 300.00 600.00
Order processing 210.29 210.29 210.29 210.29 210.29
Total cost ( 1 unit ) 613.89 713.49 813.09 1012.29 1510.29
Total cost ( 10 units )
Direct costs*10 + Overheads 3706.29 4162.29 4618.29 5530.29 7810.29
Total cost ( 50 units )
Direct costs*50 + Overheads 17450.29 19490.29 21530.29 25610.29 35810.29

With the new costing method, we recommend that Siemens should frame policies to
discourage small orders and incentivize customers to order in higher quantities (10 or
more) to reduce cost per unit and maximize profits because as per the new system of
costing, it is more beneficial to the company (refer to exhibit 3).