200 Part 1 Chapters 1-4 CableTech Bell Corporation (C78) operates in the telecornmunications industry. CTB has two divisions: the Phone Division and the Cable Service Division. The Phone Division manufactures telephones in several plants located in the Midwest. The product lines run from relatively inexpensive touch-tone wall ‘and desk phones to expensive, high-qualty cellular phones. CTB also operates a cable TV service in ‘Ohio, The Cable Service Division offers three products» basic package with 25 channels; n enhanced package, which isthe basic package plus 15 additional channels and two movie channel; and @ pre ‘rium 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 Merch Basic Enhanced Premium Sales (units) 50,000) 500,000 300,000 Price per unit $16 $30 540 Unit costs: Directly taced $3 ss $7 Driver traced $2 $4 36 Allocated $10 S13 S15 The unit costs are divided as follows: 70 percent production and 30 percent marketing and customer service, Direct labor cost isthe only driver used for tracing. Typiealy, the division uses only production Costs to define unit costs. The preceding unit product cost information was provided atthe request of the marketing menager and was the result of @ special study. Bryce Younge's, the president of CTB, is reasonably satisfied with the performance of the Cable Service Division. March's performance is firly typical of what has been happening over the past two years. The Phone Division, however, is another matter. Its overali profit perfornance has been dectin- ing, Two years ago, income before income taxes had been about 25 percent of sales. March's disrnal performance was also typical for what hes 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 + 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 lant and equipment depreciation 50,000 Materals hanclling 85,000 Inspections 60,000 Scheduling 30,000 Power 30,000 Plant supervision 12,000 a/c con‘Making the Connection 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 (esginning 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 oftheir recorded conversation is given next Bryce: "March's profit performance is dewa once again, and {think we noad to see if we can identity the problem and correct it—before is too late. Kim, what's your assessment of the situation?” Kim: *Foreign competition is eating us alive. They are coming in with lower-priced shones of compa- rable 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 ight fwe could lower ou prices by 10 to 15 percent, |think that we'd regain most of our Tost market shar. But we also naed to make sure thatthe quality of our products meets that of ourcompet- 1s. Asyou know, we are spending alot of money each month on rework and warranties. That wories me Tike 10 se that waranty cost cut by 70 to 80 percent. f we could do that, then customers would be more satisfied with our product, and bet that we would notonly regain our marke share butincrease it." Jacob: “Lowering prices without lowering perunit costs wll not help us increase our profitability. | think we need to improve our cost accounting system. | am not confident that we really know how tmuch each of our product ines is costing us. It may be that we are overpricing some of our unite because we are overcosting them. We may be underpricing other unis.” Larry: "This sounds promising—especially if the overcosting is for some of our high-volume fines. A price decrease for these products would make the biggest cifference—and if wa knew they were aver- costed, then we could offer immediate price reductions.” Bryce: "Jacob, | need more explanation, We have been using the same cost accounting system for the last 10 years. Wry 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 cifeent products using direct labor cost, a unit-based cost diver. We may be doing more allocation then 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 ccomputar technology has changed over time, its easier and cheaper to collect and use detelled infor- ration—information that will allow us to assign costs more accurately.” Bryce: is may be somathing we should explore. Jacob, what do you suggest?" Jacob: “Ifwe want more accurate product costs and ifwe really want to getin the cost reduction business, then we need to understand how costs behave. n particular, we need to understand activity cost behavior, Knowing what activities we perform, why we perform them, and how well we perfor them will help us identify areas forimprovernent, We also need to know how the different products consume activity resour ‘ces. What this boils down to is the need to use an actvity-based management system. But before we jump into ths, we need some idea of whether non-unit-based divers add anything. Activty-based management isnot an inexpensive undertaking, So | suggest that we do a preliminary study to see if crect labor costs adequate for tracing. Ifnot, then may some non-unit-crivers might be needed. In fac, you would like, ‘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 yaur division.” Kim: "What Jacob has said sounds promising. | think he should pursue it nd do so quickly also think that we need to look at improving our quality. It sounds like we have a problem there. If quality could bbe improved, then our costs wil drop. I'l talk to our quality people. Jacob, in the meantime, find out for us if moving to an activitybased systom isthe way to go. How much time do you need?” Jacob: "| have already been gathering data. | could probably have a report within two weeks.”202 ‘Making the Connection MEMO To: Kim Breashears FROM: Jacob Carder SUBJECT: Preliminary Analysis Based on my inital analysis, | am confident that an ABC system will offer significant improvement. For ‘one of our conventional phone pints, | regressed total monthly overhead cost on monthly direct labor cost using the following 15 months of data Overhead rect Labor Cost $360,000 $110,000 300,000 1100000 350,000 90,000 400,000 1100000 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 lrect labor cost appears to be a diiver of overhead cost, it realy doesn’t explain a lot of the variation. | then searched for other drivers—particularly non-unit drvers— that might offer more insight into overhead cost behavior. Every time a batch is produced, material movement occurs, regardless ofthe siz of the batch. The number of moves seemed lke 2 more logical diver. | was able to gather only 10 months of date for this. (Our information system doesn't provide the number of moves, so had to build the data set by interviewing production personnel) Ths infor- mation is provided next: Materials Handling Cost Nuriber of Moves 1,500 4,000 1.250 1,300 1.100 4,700 1,200 1350 1400 1,700 ‘The regression results were impressive. There is no question in my mind that the number of moves, isa good driver of materials-handiing costs. Using the number of moves to assign materals-hancling 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. looked at one more overhead activity: inspecting products. We have 15 inspectors who ere 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 ths idle time. | see no evidence of variable cost behavior here. I'm not exactly sure how to treat inspection cost, but | think that it is more related to inspection hours than direct labor cost. Some of the other overhead activities seem to be non-unitlevel, as well— enough, in fact, to be concerned about how we assign costs.‘After receiving the memo, Kim was Intrigued. She then asked Jacob to use the same phone pla ‘Making the Conneeton 18.2 pilot for @ preliminary ABC analysis. She instructed him to assign all overhead costs to the plant's {wo products (Regular and Deluxe models), using only four activities. The four activities were rework, moving materials, inspecting products, and a general catch-all activity labeled “other manufacturing activities.” From the special study already performed, she knew that materials handling and inspecting involved significant cost; from production reports, she also knew that the rework activity involved signif icant cost. Ifthe ABC and unit-based cost assignments did not differ by breaking out these three major activities, then ABC may not matter. Pursuant to the request, Jacob produced the following cost and driver information: Rativty Expected Cost Driver ‘Aativity Capacity Other activities {$2,000,000 Direct labor dollars $1,250,000, Moving materials ‘900,000 Number of moves 18,000 Inspecting 720,000 _laspection hours 24,000 Reworking 380,000 Rework hours 3,800 Total overhead cost $4,000,000 Expected setivty demands: Regular Model Deluxe Model Units completed 100,000 40,000 Direct labor dellars $875,000 $375,000 Number of moves 7,200 10,800 Inspection hours 6000 18,000 Rework hours 4,900 3,900 Required 1 10, 1 Compute two different unit costs for each of the Cable Service Division's products. What mana- {gorial objactives are being served by these unit cost computations? Three different cost categories are provided by the Cable Service Division: direct tracing, driver ac- ing, and allocation, Discuss the meaning of each. Based on how costs are assigned, do you think thet the Cable Service Division is using 2 funetional-based or an activity-based cost accounting system? ‘What other differences exis: between functional-based and sctivity-based cost accounting systems? Discuss the differences between the Cable Service Division's products and the Phone Division's products Prepare en income statement for the Cable Service Division for March. Propare an income statement for the Phone Division for March. Include @ supporting cost of ‘goods manufactured statement ‘The Phone Division has been using the same cost accounting system for over 10 yeers. Explain iy its cost eccounting 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 materials handling cost using number of moves as the driver. ‘Comment on Jacob Carder's clservations concerning the outcomes. How would you describe the cost behavior of the inspection activity? Assume that the quality control manager implements 2 program that reduces the number of defective units by 50 per cent. Because ofthe improved quality, the demand for inspection hours will also drop by 50 per ‘cont. What is the potential monthly reduction in inspection costs? How did knowledge of inspection’s cost behavior help? Calulate the overhead cost per unit for each phone model using direct labor cost to assign all overhead costs to products, Calculate the overhead cost par unit using the four activities and drivers identified by Kim and Ja~ cob. if you were Kim, would you be inclined to implement an ABC system based on the evidence from ths plot test? Suppose someone urged Kim to lock into Time-Driven Actvity-Based Costing (TDABC) instead ‘of ABC. What would be the advantages of using @ TDABC proach?