CASE 1

1

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 a large plant in Ohio. 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 premium 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 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 marketing and customer service. Direct labor cost is the only driver used for tracing. Typically, the division uses only production costs to define 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 satisfied 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 profit performance has been declining. 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

Material 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 significant 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 profit 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 comparable 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 competitors. 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 satisfied 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 profitability. I think we need to improve our cost accounting system. I am not confident 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 overcosted, 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 information-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 resources. 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 nonunit-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 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 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, find 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."

MEMO

TO:          -Kim Breashears

FROM:    -Jacob Carder

SUBJECT:  -Preliminary Analysis

Based on my initial analysis, I am confident that an ABC system will offer significant improvement. 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 nonunit 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 information is provided next:

Material-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 material-handling costs. Using the number of moves to assign material-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 nonunit-level, as well-enough, in fact, to be concerned about how we assign costs.

Required:

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?

Three different cost categories are provided by the Cable Service Division: direct attribution, driver tracing, and allocation. Discuss the meaning of each. Based on how costs are assigned, do you think that the Cable Service Division is using a functional-based or an activity-based cost accounting system? What other differences exist between functional-based and activity-based cost accounting systems?

3. Discuss the differences between the Cable Service Division's products and the Phone Division's products.

Prepare an income statement for the Cable Service Division for March.

Prepare an income statement for the Phone Division for March. Include a supporting cost of goods manufactured statement.

The Phone Division has been using the same cost accounting system for over 10 years. Explain why its cost accounting 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 material-handling cost using number of moves as the driver. Comment on Jacob Carder's observations concerning the outcomes.

8. How would you describe the cost behavior of the 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 inspection hours will also drop by 50 percent. What is the potential monthly reduction in inspection costs? How did knowledge of inspection's cost behavior help?