CableTech Bell Corporation (CTB) operates in the telecommunications industry. CT
ID: 2464175 • Letter: C
Question
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 several plants located in the Midwest. 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 pre- mium 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:
Basic
Enhanced
Premium
Sales (units)
50,000
500,000
300,000
Price per unit
$16
$30
$40
Unit costs:
Directly traced
$ 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 dene 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 satised 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 prot performance has been declin- ing. 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 depreciation
50,000
Materials 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 signicant 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 prot 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 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 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 competi- tors. 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 satised 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 protability. I think we need to improve our cost accounting system. I am not condent 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 over- costed, 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 infor- mation—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 resour- ces. 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 non-unit-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 non-unit-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, nd 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.”
TO: Kim Breashears
FROM: Jacob Carder
SUBJECT: Preliminary Analysis
MEMO
Based on my initial analysis, I am condent that an ABC system will offer signicant improvement. For one of our conventional phone plants, I regressed total monthly overhead cost on monthly direct labor cost using the following 15 months of data:
Overhead
Direct 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 non-unit 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 infor- mation is provided next:
Materials-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 materials-handling costs. Using the number of moves to assign materials-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 non-unit-level, 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 plant as a pilot for a preliminary ABC analysis. She instructed him to assign all overhead costs to the plant’s two 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 signicant cost; from production reports, she also knew that the rework activity involved signif- icant cost. If the 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:
Activity
Expected Cost
Driver
Activity Capacity
Other activities
$2,000,000
Direct labor dollars
$1,250,000
Moving materials
900,000
Number of moves
18,000
Inspecting
720,000
Inspection hours
24,000
Reworking
380,000
Rework hours
3,800
Total overhead cost
$4,000,000
Expected activity demands:
Regular Model
Deluxe Model
Units completed
100,000
40,000
Direct labor dollars
$875,000
$375,000
Number of moves
7,200
10,800
Inspection hours
6,000
18,000
Rework hours
1,900
1,900
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?
Basic
Enhanced
Premium
Sales (units)
50,000
500,000
300,000
Price per unit
$16
$30
$40
Unit costs:
Directly traced
$ 3
$ 5
$ 7
Driver traced
$ 2
$ 4
$ 6
Allocated
$10
$13
$15
Explanation / Answer
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