Question: Activity-Based Supplier Costing

Levy Inc. manufactures tractors for agricultural usage. Levy purchases the engines needed for its tractors from two sources: Johnson Engines and Watson Company. The Johnson engine has a price of $1,000. The Watson engine is $900 per unit. Levy produces and sells 22,000 tractors. Of the 22,000 engines needed for the tractors, 4,000 are purchased from Johnson Engines, and 18,000 are purchased from Watson Company. The production manager, Jamie Murray, prefers the Johnson engine. However, Jan Booth, purchasing manager, maintains that the price difference is too great to buy more than the 4,000 units currently purchased. Booth also wants to maintain a significant connection with the Johnson source just in case the less expensive source cannot supply the needed quantities. Jamie, however, is convinced that the quality of the Johnson engine is worth the price difference. Frank Wallace, the controller, has decided to use activity costing to resolve the issue. The following activity cost and supplier data have been collected:

Activity                               Cost

Replacing engine            $ 800,000

Expending orders            1,000,000

Repairing engines            1,800,000

a. All units are tested after  assembly, and some are rejected because of engine failure. The failed engines are removed and replaced, with the supplier replacing any failed engine. The replaced engine is retested before being sold. Engine failure often causes collateral damage, and other parts often need to be replaced.

b. Due to late or failed delievery of engines.

c. Repair work is for units under warranty and almoist invariably is due to engine failure. Repair usually means replacing the engine. This cost plus labor, transportation, and othert costs make earranty work very expensive.
   
                                              Watson             Johnson

Engines replaced by source            1,980               20

Late or failed shipments                   198                2

Warranty repairs (by source)          2,440               60

Required: 1. Conceptual Connection: Calculate the activity-based supplier cost per engine (acquisition cost plus supplier-related activity costs). Which of the two suppliers is the low-cost supplier? Explain why this is a better measure of engine cost than the usual purchase costs assigned to the engines.

2. Conceptual Connection: Consider the supplier cost information obtained in Requirement 1. Suppose further that Johnson can only supply a total of 20,000 units. What actions would you advise Levy to undertake with its suppliers?