CableTech Bell Corporation industry

CableTech Bell Corporation (CTB) operates in" rel="nofollow">in the telecommunications in" rel="nofollow">industry. CTB has two divisions: the Phone Division and the Cable Service Division. The Phone Division manufactures telephones in" rel="nofollow">in a large plant in" rel="nofollow">in Ohio. The product lin" rel="nofollow">ines run from relatively in" rel="nofollow">inexpensive touch-tone wall and desk phones to expensive, high quality cellular phones. CTB also operates a cable TV service in" rel="nofollow">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 premium package which is the basic package plus 25 additional channels and three movie channels. The Cable Service Division reported the followin" rel="nofollow">ing 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 attributable $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 marketin" rel="nofollow">ing and customer service. Direct labor cost is the only driver used for tracin" rel="nofollow">ing. Typically, the division uses only production costs to defin" rel="nofollow">ine unit costs. The precedin" rel="nofollow">ing unit product cost in" rel="nofollow">information was provided at the request of the marketin" rel="nofollow">ing manager and was the result of a special study. Bryce Youngers, the president of CTB, is reasonably satisfied with the performance of the Cable Service Division. March’s performance is fairly typical of what has been happenin" rel="nofollow">ing over the past two years. The Phone Division, however, is another matter. Its overall profit performance has been declin" rel="nofollow">inin" rel="nofollow">ing. Two years ago, in" rel="nofollow">income before in" rel="nofollow">income taxes had been about 25 percent of sales. March’s dismal performance was also typical for what has been happenin" rel="nofollow">ing this year and is expected to contin" rel="nofollow">inue—unless some action by management is taken to reverse the trend. Durin" rel="nofollow">ing March, the phone division reported the followin" rel="nofollow">ing results: Inventories: Materials, March 1 $ 23,000 Materials, March 31 40,000 Work in" rel="nofollow">in process, March 1 130,000 Work in" rel="nofollow">in process, March 31 45,000 Fin" rel="nofollow">inished goods, March 1 480,000 Fin" rel="nofollow">inished goods, March 31 375,000 Costs: Direct labor $117,000 Plant and equipment depreciation 50,000 Material handlin" rel="nofollow">ing 85,000 Inspections 60,000 Schedulin" rel="nofollow">ing 30,000 Power 30,000 Plant supervision 12,000 Manufacturin" rel="nofollow">ing engin" rel="nofollow">ineerin" rel="nofollow">ing 21,000 Sales commissions 120,000 Salary, sales supervisor 10,000 Supplies 17,000 Warranty work 40,000 Rework 30,000 Durin" rel="nofollow">ing March, the Phone Division purchased materials totalin" rel="nofollow">ing $312,000. There are no significant in" rel="nofollow">inventories of supplies (begin" rel="nofollow">innin" rel="nofollow">ing or endin" rel="nofollow">ing). Supplies are accounted for separately from materials. CTB’s Phone Division had sales totalin" rel="nofollow">ing $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 profit performance is down once again" rel="nofollow">in, and I thin" rel="nofollow">ink 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 eatin" rel="nofollow">ing us alive. They are comin" rel="nofollow">ing in" rel="nofollow">in with lower-priced phones of comparable or higher quality than our own. I’ve talked with several of the retailers that carry our lin" rel="nofollow">ines, and they say the same. They are convin" rel="nofollow">inced 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 thin" rel="nofollow">ink that we’d regain" rel="nofollow">in most of our lost market share. But we also need to make sure that the quality of our products meets that of our competitors. As you know, we are spendin" rel="nofollow">ing 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 satisfied with our products, and I bet that we would not only regain" rel="nofollow">in our market share but in" rel="nofollow">increase it.” Jacob: “Lowerin" rel="nofollow">ing prices without lowerin" rel="nofollow">ing per-unit costs will not help us in" rel="nofollow">increase our profitability. I thin" rel="nofollow">ink we need to improve our cost accountin" rel="nofollow">ing system. I am not confident that we really know how much each of our product lin" rel="nofollow">ines is costin" rel="nofollow">ing us. It may be that we are overpricin" rel="nofollow">ing some of our units because we are overcostin" rel="nofollow">ing them. We may be underpricin" rel="nofollow">ing other units.” Larry: “This sounds promisin" rel="nofollow">ing—especially if the overcostin" rel="nofollow">ing is for some of our high-volume lin" rel="nofollow">ines. A price decrease for these products would make the biggest difference—and if we knew they were overcosted, then we could offer immediate price reductions.” Bryce: “Jacob, I need more explanation. We have been usin" rel="nofollow">ing the same cost accountin" rel="nofollow">ing system for the last 10 years. Why would it be a problem?” Jacob: “I thin" rel="nofollow">ink that our manufacturin" rel="nofollow">ing environment has changed. Over the years, we have added a lot of different product lin" rel="nofollow">ines. Some of these products make very different demands on our manufacturin" rel="nofollow">ing overhead resources. We trace—or attempt to trace—overhead costs to the different products usin" rel="nofollow">ing direct labor cost, a unit-based cost driver. We may be doin" rel="nofollow">ing more allocation than tracin" rel="nofollow">ing. 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 in" rel="nofollow">information—in" rel="nofollow">information that will allow us to assign costs more accurately.” Bryce: “This may be somethin" rel="nofollow">ing we should explore. Jacob, what do you suggest?” Jacob: “If we want more accurate product costs and if we really want to get in" rel="nofollow">in the cost reduction busin" rel="nofollow">iness, then we need to understand how costs behave. In particular, we need to understand activity cost behavior. Knowin" rel="nofollow">ing 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 resources. What this boils down to is the need to use an activity-based management system. But before we jump in" rel="nofollow">into this, we need some idea of whether nonunit-based drivers add anythin" rel="nofollow">ing. Activity-based management is not an in" rel="nofollow">inexpensive undertakin" rel="nofollow">ing. So I suggest that we do a prelimin" rel="nofollow">inary study to see if direct labor cost is adequate for tracin" rel="nofollow">ing. If not, then maybe some nonunit-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 thin" rel="nofollow">ink, Kim? It’s your division.” Kim: “What Jacob has said sounds promisin" rel="nofollow">ing. I thin" rel="nofollow">ink he should pursue it and do so quickly. I also thin" rel="nofollow">ink that we need to look at improvin" rel="nofollow">ing 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" rel="nofollow">in the meantime, fin" rel="nofollow">ind out for us if movin" rel="nofollow">ing to an activity-based system is the way to go. How much time do you need?” Jacob: “I have already been gatherin" rel="nofollow">ing data. I could probably have a report within" rel="nofollow">in two weeks.” MEMO TO: Kim Breashears FROM: Jacob Carder SUBJECT: Prelimin" rel="nofollow">inary Analysis Based on my in" rel="nofollow">initial analysis, I am confident that an ABC system will offer significant improvement. I regressed total monthly overhead cost on monthly direct labor cost usin" rel="nofollow">ing the followin" rel="nofollow">ing 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 revealin" rel="nofollow">ing. Although direct labor cost appears to be a driver of overhead cost, it really doesn’t explain" rel="nofollow">in a lot of the variation. I then searched for other drivers—particularly nonunit drivers—that might offer more in" rel="nofollow">insight in" rel="nofollow">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 in" rel="nofollow">information system doesn’t provide the number of moves, so I had to build the data set by in" rel="nofollow">interviewin" rel="nofollow">ing production personnel.) This in" rel="nofollow">information is provided next: Material-Handlin" rel="nofollow">ing 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" rel="nofollow">in my min" rel="nofollow">ind that the number of moves is a good driver of material-handlin" rel="nofollow">ing costs. Usin" rel="nofollow">ing the number of moves to assign material-handlin" rel="nofollow">ing costs to products would likely be better than the cost assignment usin" rel="nofollow">ing direct labor cost. Furthermore, sin" rel="nofollow">ince small batches use the same number of moves as large batches, we have some evidence that we may be overcostin" rel="nofollow">ing our high-volume products. I looked at one more overhead activity: in" rel="nofollow">inspectin" rel="nofollow">ing products. We have 15 in" rel="nofollow">inspectors who are paid an average of $4,000 per month. Each in" rel="nofollow">inspector offers about 160 hours of in" rel="nofollow">inspection capacity per month. However, it appears that they actually work only about 80 percent of those hours. The drop in" rel="nofollow">in demand we have experienced explain" rel="nofollow">ins this idle time. I see no evidence of variable cost behavior here. I’m not exactly sure how to treat in" rel="nofollow">inspection cost, but I thin" rel="nofollow">ink that it is more related to in" rel="nofollow">inspection hours than direct labor cost. Some of the other overhead activities seem to be nonunit- level, as well—enough, in" rel="nofollow">in fact, to be concerned about how we assign costs. Required: 4. Prepare an in" rel="nofollow">income statement for the Phone Division for March. Include a supportin" rel="nofollow">ing cost of goods manufactured statement. 5. The Phone Division has been usin" rel="nofollow">ing the same cost accountin" rel="nofollow">ing system for over 10 years. Explain" rel="nofollow">in why its cost accountin" rel="nofollow">ing system may be outmoded. What factors determin" rel="nofollow">ine when a new cost accountin" rel="nofollow">ing system is warranted? 6. Usin" rel="nofollow">ing the method of least squares, calculate two cost formulas: one for overhead usin" rel="nofollow">ing direct labor cost as the driver, and one for material-handlin" rel="nofollow">ing cost usin" rel="nofollow">ing number of moves as the driver. Comment on Jacob Carder’s observations concernin" rel="nofollow">ing the outcomes. 8. How would you describe the cost behavior of the in" rel="nofollow">inspection activity? Assume that the quality control manager implements a program that reduces the number of defective units by 50 percent. Because of the improved quality, the demand for in" rel="nofollow">inspection hours will also drop by 50 percent. What is the potential monthly reduction in" rel="nofollow">in in" rel="nofollow">inspection costs? How did knowledge of in" rel="nofollow">inspection’s cost behavior help?