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 enginesa	$800,000
Expediting ordersb	1,000,000
Repairing enginesc	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 delivery of engines.

c Repair work is for units under warranty and almost invariably is due to engine failure. Repair usually means replacing the engine. This cost plus labor, transportation, and other costs make warranty 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. Calculate the activity-based supplier cost per engine (acquisition cost plus supplier-related activity costs). (Round to the nearest cent.)

Watson	$ per engine
Johnson	$ per engine

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.

The engine costs less when the full supplier effects are considered. This is a better assessment of cost because it considers the costs that are caused by the supplier due to poor quality, poor reliability, and poor delivery performance.

2. 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?

In the short run, buy 20,000 from and 2,000 from . In the long run, one possibility is to encourage to increase its quality and maintain purchases from both sources (lowers source risk by having two suppliers).

Answer 1

SOLUTION

1. Computation of Actvity Cost Rate for Activity cost pool-

	Total estimated cost (A)	Basis of allocation	Total activity (B)	Cost activity (A/B)
Replacing engines	800,000	Engines replaced by source	2,000	$400
Expediting orders	1,000,000	Late or failed shipments	200	$5,000
Repairing engines	1,800,000	Warranty repairs	2,500	$720
	3,600,000

The supplier related activity cost per unit is as under:

	Watson ($)	Johnson ($)
Replacing engines	792,000 (1980*$400)	8,000 (20*$400)
Expediting orders	990,000 (198*$5,000)	10,000 (2*$5,000)
Repairing engines	1,756,800 (2440*$720)	43,200 (60*$720)
Total Cost	3,538,800	61,200
Number of units	22,000	4,000
Cost per unit	160.85	15.30

The activity-based supplier cost per engine-

	Watson ($)	Johnson ($)
Acquisition cost	900	1,000
Add: Supplier related activity cost	160.85	15.30
Total cost	1,060.85	1,015.30

Johnson is a low cost supplier.

2. In the short run, buy 20,000 from Johnson and 6,000 from Watson. In the long run, one possibility is to encourage watson to increase its quality and maintain purchases from both sources (lowers source risk by having two suppliers).