S78 Part 2 Management Accounting Case 18-4 Safety Monitoring Devices, Inc.* At the end of the day we look at the money in the bank. After each performance period we ask our- selves. s there more here today than there was ‘yesterday, and is the incremental amount accept- able and within the goals and targets that we have set? Ifthe answers to those questions are yes, then the company is on track. Changing the cost system is just like playing an expensive numbers game, —Mark Holder, Controller, Safety Monitoring Devices, Inc. Safety Monitoring Devices, Inc. (SMD) was founded in Oxnard, California, in 1986 by Richard Chen: Richard, who had degree in material sciences from the University of California at Santa Barbara, deyel- ‘oped a portable gas safety monitor. SMD initially focused on manufacturing and selling portable oxygen deficiency monitors. Tn 2001 it added other portable toxic gas monitors to its offerings. Even though com- Petitors had entered the market and competition was intensifying, SMD still enjoyed a strong reputation for producing high quality, reliable portable safety moni- tors. SMD¥s products were expensive, but Richard was proud that his company’s products saved lives by pro- viding gas safety monitoring in places where larger, fixed units could not be taken. Oxygen deficiency (OD) hazards are not just lim- ited to industrial settings; they also frequently occur at home and even at play. At work, OD concerns are pre- sent in virtually all industries, Waste treatment plant workers, tunnel cleaning crews, and even farmers in their barns, just to name a few, all face potential OD hazards. At home, OD is mostly caused by heating sys- ‘tems that are poorly vented in confined spaces, such as bathrooms, basements, and garages. And, at play, OD problems frequently occur at indoor stadiums, particu- larly those hosting automotive events. OD is highly dangerous and requires preventive measures to ayoid accidents. There is often little warning before OD inhibits a person’s ability to seek safety, With such a wide range of applications, SMD had experienced a steady increase in demand for its oxy- gen deficiency detectors (ODDs) in almost every year of ‘its existence, except in the recession year of * Copyright © by Wim A. Van der Stede, 1990-91 when demand was about flat. In the mid: to late-19908, SMD outgrew its existing facilities, Irbuilt new state-of-the-art production facility about a mile away from the original facility, which’ was subse- quently closed and sold, ‘The new facility was dedicated in 2001. The state- ofthe-art machinery in the new facility was config- ured into a cellular manufacturing layout, The plant ‘was built to a capacity of 1.5 times the then-current de- ‘mand, for two teasons. First, SMD expected demand for ODDs to continue to grow. Second, SMD had begun the development of its second product line: toxie gas detectors (TGDs). The first of four types of ‘TGDs (carbon monoxide) went into production in December 2001, followed by a staggered introduction of the other three (chlorine dioxide, nitrogen dioxide, and sulfur dioxide) in approximately six-month indre- ments, By mid-2003, all four TGDs were available for sale. SMD’ sales philosophy was to earn consistently solid margins. “We do not want to compete based on lowest price, so we rarely discount,” said Lourdes Sandino, VP Marketing & Sales. Prices were set to yield, roughly, a markup of 30 percent on a full cost basis, To estimate full product costs, Mark Holder, Controller, spread the totality of all overhead costs to products based on the products’ usage of direct labor hours in the production process. All four types of TGDs (carbon monoxide, chlorine dioxide, nitrogen dioxide, and sulfur dioxide) incurred roughly the same direct material and labor costs, so for reporting pur- poses, cost data were grouped into the two product lines only: ODDs and TGDs, Budgeted production data; unit standard direct material and labor costs; and budgeted overhead costs for fiscal year 2005 are shown in Exhibits 1, 2, and 3, respectively. Based on these budget data and margin requirements, the sug- ‘gested unit sale prices were set at $300 for ODDs and $330 for TGDs. Since SMD moved into the new facility in 2001, Lourdes found herself addressing increasingly fre- quent requests from sales reps to discount ODDs, A few of the requests were made for large quantity or- ders, but more frequently the rationale was that SMD's price-quality proposition for ODDs was out of lineChapter 18 Additonal Aspects of Product Costing Systems $79 EXHIBIT 1 Safety Monitoring Devices, Inc.: 2005 Budgeted Production and Activity Levels ‘opps* TGDs* Production Volumes) 25,000 units 12,500 units Production Runs 24 batches 96 batches Purchasing Orders 90 POs 210 POs Product Shipments 80 shipments 320 shipments Part Numbers per Unit 18 parts 32 parts Direct Labor Hours per Unit 4 hours 4 hours Machine Hours per Unit 3 hours S hours ODD = Oxygen dfeleny detectors, TOD = Tone xs detector (8-The budget asunes no chang in inventories and hence, production volumes (ont) are budgeted be equal sles eles (oi). EXHIBIT 2 Safety Monitoring Devices, Inc.: 2005 Standard Direct Material ‘and Labor Costs per Unit i ‘ops Tobs 3 Direct Material Cost ; $88 sit Direct Labor Cost (aia 64 , 3152 $175 Eee rh AN eee ee EXHIBIT 3 Safety Monitoring Devices, Inc.: 2005 Budgeted Overhead Costs NSIS Ea a ae ae Corporate Overhead (in $000) RED. $300 Marketing 380 General Administration 750 Total Corparate Overhead Costs $1,430 Manufacturing Overhead Purchasing $120 Materials Handling 125 Machine Setup 180 Supervision 225 Quality Control 195 Packaging & Shipping 210 Machine Depreciation 165 Plant (incl. Upkeep, Depreciation, Property Taxes, and Insurance) 240 Miscellaneous (e.g, Indirect Materials) 110 Total Manufacturing Overhead Costs $1,570 with the competition, A downward trend in ODD similar pressures to discount TGDs. and demand for ‘sales, from 28,350 units in 2001 to an expected 25,000 TGDs had not fallen. As shown in Exhibit 1, TGDs units in 2005, had caused Lourdes to become more were expected to grow to one-third of SMD's total prone to allow the discounts. Lourdes had not noticed sales in units by 2005, which was quite remarkable$80 Port 2 Management Accounting EXHIBIT 4 Safety Monitoring Devices, Inc.: Proposed Overhead Cost Allocation Bases (“Drivers”) Corporate Overhead Suggested “Driver” R&D Product Type® Marketing Product Lines” General Administration Production Units Manufacturing Overhead Purchasing Purchase Orders Materials Handling Part Numbers Machine Setup Batches Supervision Direct Labor Hours Quality Control Production Units Packaging & Shipping Shipments Machine Depreciation Machine Hours Plant (incl, Upkeep, Depreciation, Property Taxes, and Insurance) Production Units Miscellaneous (e.g,, Indirect Materials) Machine Hours (© There are five Produ Type: (1) Oxygen; 2) Carbon Movoride (3) Chlorine Dioxide; (4) Nitrogen Dioxide; and (5) Sulfur Dioxide (© Ther are two Product Lines: (1) Oxygen Deficiency Detection (ODD) and (2) Tonle Gas Detection (TAD) uziven the relatively recent introduction of the TGD. product lines. Lourdes had developed several hypotheses about ‘what might have caused the price pressure on ODDs. Product costing was one possible factor she had considered. Tam naturally nota gifted numbers person. I still remember vividly, or should I say horribly, how I struggled in my cost accounting class during my MBA days in terms of actually applying the con- ‘cepts to the cases and figuring out which numbers to work with, But I do remember the punch line of many of these cases: How product costing distor- tions could lead to flawed product offering and pric- ‘ng decisions and, in some cases, company failure. I sure hope SMD is not headed in that direction, ethaps unfortunately, Mark Holder [corporate con- troller), who maintains direct responsibility for our ‘cost accounting systems, is very defensive to even, the slightest questioning of our current product ‘costing method. And because T'm not an expert in accounting, I don’t want to go too far with the ques tioning because I know he wil either belittle my accounting savvy or, worse, blame the company's performance problems on the sales organization, I raised the cost accounting issue in 2003 when the TGDs were fully introduced and the company. hhad some exceptional growth targets for the next several years. | asked if it might be in the best in- terest of the company to make sure to understand the “true costs” of our various products, Mark said that only when we introduce many more products might it make sense to have a more elab- ‘rate cost system. I wondered though whether it ‘wouldn't be easier to initiate a new cost system sooner, rather than later, when we have even more ‘products and more variables to worry about? His response was that the way we track costs is neither right uor wrong; its really just company policy. ‘That is where we left the discussion. In’the February 2005 executive meeting, Greg ‘Weiss, VP-Manufacturing, said that he thought the company should be working toward what he called an activity-based cost (ABC) system. As Greg described. it, the essence of an ABC system is to identify the major activities that cause the company’s overhead | costs to be incurred and then to apply those costs to products based on the products’ consumption of each of those activities. Greg's key point was that using @ single, standard overhead rate and applying it to all the products did not make sense because, clearly there are differences in volume and resource utilization across the ODD and TGD product lines. Richard, however,Chapter 18 dona Aspects of Product Contin Stems SB the issue because Mark was not Gua: ard warned, though, that in ofder to be ‘to convince Mark and himself, Greg needed to 1, Caleutate the full cost per unit of ODD and 'TGD: a. Using the existing costing method. b. Using Greg’s proposed ABC method (thus using e a strong case for change, backed by hard-and- Lourdes, was not sure why Greg had raised this e. Unlike her, Greg’s bonus was not dependent on jins; it was based on his ability to meet his bud- for total manufacturing costs.' Anyhow, she the suggested “driver” information shown in Exhibit 4 of the case), ©. Using an “in-between” costing method that lled Greg after the meeting because she thought the issue he had raised was related to the concern had tried: to discuss with Mark before. Greg }to meet with Lourdes the next week. At that ‘Greg showed her the information provided Greg and Lourdes intended to propose if they were unable to convince Richard and Mark that the ABC method should be adopted. The “in- ‘between method” proposes to allocate overhead costs based:on two drivers only: direct material cost and machine hours, as shown in Exhibit 5. ici ancsmnts Sonar ed production costs were “tlexed” to reflect actual production volume i it happened to deviate from budge! using the budget data in Exhibits 1 and 2 for fiscal year 2005, Greg would be considered to ctual manufacturing costs for 2005 would equal (25,000 units « $152) + (12,500 units « $175) + 1, Fess. if, however, actual olures in 2005 were to have been 20,000 unt fo O 16 20,000 uns 152) «16000 unis» $175) = [26002. Why were (a) Lourdes and (b), Greg gas in having the company change its cost system? 3. What are the effects, if any, of changing the com- pany’ costing method? Specifically, are the differ- ences between these three methods significant in terms of a. Their effect on individual product costs? b. Their effect on cotal company profits (assuming that there are no changes; in any operating deci- sions, such as regarding prices and production volumes)? Where the differences are significant, explain why they exist: If there are:no differences, or if the dif- ae are not sighi en why this is the ease. aout 4. Do is i Hi as ‘Cause of the re- quests. that Lourdes was ‘receiving to discount ODDs back in 2001, when SMD was still a one- product, ODD-onty company? Would it have made Sense to start imiplementing ABC at that time? 5. What should SMD management do regarding its ‘cost system? (To the extent that they exist, discuss the advantages and disadvantages of cach alterna- ive. Why did you recommend the alternative that you chose? Explain.) — summary iacome statement i Be : ¥ Office Products was a regional distributor of office supplies to institutions and commercial busi nesses. It offered a comprehensive product line rang- from simple Writing implements (such as pens, or Rober S, Kaplan, it © by the President and Fellows of Harvard College. Harvard Business School ease 102-021. at shipments of pr from manufacturers, and moved the cartons into desi inated storage locations until customers requested the) items. Each day, afler customer orders had been re- ceived, DOP personnel drove forklift trucks around th ‘warehouse to accumulate th ‘of items and p pared them for shipment, ‘Typically, DOP shipped’ products to its customer Using commercial truckers. Recently, DOP had attracte Pou egiesaeiary eres erin! expebi i sexperises(exelud