Question

We constantly seem to be pricing ourselves out of some markets and not charging enough in others. Our pricing policy is pretty simple: we mark up our full manufacturing cost by 50%. That means a computer that costs us $2,000 to manufacture will sell for $3,000. Until now I thought this was a workable approach, but now I’m not so sure.

Steve Works, CEO, Cortland Manufacturing, Inc. (CMI)

Steve’s Controller, Sally Nomer, had just told him that she believed the computers might be priced inappropriately. Steve continued:

When I was at Leland [School of Management] I focused most of my attention on operations and marketing, convinced that those were the keys to my successful career. Cost accounting was boring and not relevant. But now my accountant is telling me that I need to think about a new way to assign manufacturing overhead to products, and I don’t even know where to start! I never dreamed that some day my career would come to this. I wish I’d paid more attention to those classes so I could understand what is going on here. I’m lost.

BACKGROUND

CMI manufactures several different models of computers, distributed to retail outlets throughout the 50 states. The company is proud of the user-friendly computers it produces, in particular their graphics capability. CMI claims the superb graphics are what distinguish its products from competitors.

CMI purchases raw materials in components and subassemblies made to its specifications from a very small group of highly reliable suppliers. It uses a single facility to house both manufacturing facility and administrative and sales offices. The factory workers operate three kinds of machines. Inspecting machines check the raw materials and test components and subassemblies to assure they are working to specifications. Soldering machines solder various components as necessary. Finally assembly machines put all the components and subassemblies together into finished computers. The processes can vary by computer model.

Depreciation, maintenance and repairs on the three types of machines account for about 40% of CMI’s overhead cost. The remainder of the overhead is made up of labor involved in receiving and handling the raw materials, adjusting and setting up machines for each new batch of computers, and inspecting and packing finished computers for shipping. Additional costs include insurance and depreciation on handling equipment, supplies, and utilities. The actual manufacturing effort (soldering, inspecting and assembly) is primarily automated, so CMI uses very little direct labor. The company also operates on a lean production model, so almost no inventories exist at the end of any period.

Most of the computers are sold in large orders to national electronic chains. However, the Cortland 2000 is not such a machine. It represents a recent effort by CMI to enter the scientific computing market. The quantity manufactured and sold of this machine is expected to be much lower than other models even when it gains its hoped-for market share. Fewer customers exist for this more sophisticated, powerful, high-priced machine. Nonetheless, Mr. Works has believed from the conception of this product that, when all manufacturing costs were considered, the Cortland 2000 would contribute a reasonable amount to CMI’s selling and administrative costs and profit. The name recognition it brought in its elite community should enhance sales of the more generally used computers.

FINANCIAL INFORMATION

CMI budgeted direct labor costs for 2010 at $60,000,000. Based on expected sales, the company estimated that raw material purchased and used would be $300,000,000. Manufacturing overhead was budgeted at $196,000,000. It is currently allocated to production on the basis of machine hours (MH). As mentioned above, computers are priced at full production cost plus a mark-up of 50%.

EXHIBIT 1 shows the expected direct manufacturing costs for two of the company’s computers. The Cortland 1000 is a very popular computer with a large production and sales volume. By contrast, the Cortland 2000, described above, is a state-of-the-art scientific computer with several special features. In particular, the Cortland 2000

a. Uses a new processing chip imported from Sweden.

b. Has special patented random access memory (RAM) that gives it extremely high input/output speed.

c. Is manufactured in very small batches to assure uniform quality from one computer to the next, to satisfy the users of the machines who have very high expectations for the performance of the machines they purchase.

Mr. Works’ concerns arose when Ms. Nomer told him that she thought the company’s traditional overhead allocation system was providing misleading cost information about the different types of products. She developed an analysis of the 2010 manufacturing overhead costs, shown in EXHIBIT 2. She classified the overhead costs described above into activities. She also gathered data, shown in EXHIBIT 3, for the 2010 production of the Cortland 1000 and the Cortland 2000. Mr. Works commented on the data:

I don’t know quite what to make of all this. Clearly I need some further explanation and analysis. I guess what I really need is some sense of what is the true manufacturing cost of each computer. I thought I knew that, but I didn’t really. Even though we cannot at this point change prices for 2010, we at least need to know if we’re covering full production cost on the Cortland 2000 and have something left to contribute to the company’s selling, general and administrative expenses. I thought this was so, but now … well, I’m not so sure. We’d better figure this out before we begin our budget cycle for 2011. Maybe I need to go back to school!

EXHIBIT 1

Direct Manufacturing Costs for ONE Computer

Cortland 1000

Cortland 2000

Direct Material

$1,000

$2,500

Direct Labor

$200

$400

EXHIBIT 2

Analysis of 2010 Budgeted Manufacturing Overhead Costs

Activity

Cost driver

Budgeted activity (for entire company)

Budgeted cost

Receive/handle raw material

Orders received

200 orders

$90,000,000

Adjust/set up machines

Number of setups

2,000 setups

$12,000,000

Inspect, pack, ship computers

Batches

500 batches

$60,000,000

Inspect raw materials

Inspection hours

200,000 insp. hr.

$10,000,000

Solder parts

Soldering hours

200,000 sdr. hr.

$12,000,000

Assemble computers

Assembly hours

100,000 assm. hr.

$12,000,000

Total overhead

$196,000,000

EXHIBIT 3

Production Data for Cortland 1000 and Cortland 2,000 Computers

Item

Measure

Cortland 1000

Cortland 2000

Budgeted production

Number of computers

20,000

5,000

Received order size*

Size of order

10,000

500

Batch size

Number of computers

5,000

100

Machine setups

Number of s/u per batch

5

6

Inspecting time (Raw mat.)

Hours / computer

1

2

Soldering time

Hours / computer

3

1

Assembly time

Hours / computer

1

1

* “Received order size” is the number of computers one order of raw materials will build. Thus, for example, (see above) the company receives 2 orders of raw materials for the Cortland 1,000. Calculation: 20,000 computers per year, divided by 10,000 computers each order will build = 2 orders per year.

REQUIRED:

Don’t try to begin answering questions until you have studied the case information carefully. Careless reading will result in careless errors! Just take a few extra minutes to understand it all.

1. Calculate the predetermined overhead rate the company is currently using. (Where should you look for the machine hours?)

2. Using the information from the exhibits and Q1, calculate the manufacturing cost of ONE Cortland 1000 and ONE Cortland 2000.

3. Calculate the selling price, under the current system, of ONE Cortland 1000 and ONE Cortland 2000.

4. Next, you are going to begin to analyze the ABC system. In order to do this, however, your study of Exhibits 2 and 3 should have told you that you are going to have to convert the information the company currently measures into the information you need for the ABC analysis. First, how many raw material orders did the company receive for each model?

5. How many batches of each model did the company pack and ship?

6. How many machine setups does Cortland do for each model?

7. Calculate a rate for each activity in Exhibit 2.

8. Use the rates calculated in Q7 to apply overhead to each product line: Cortland 1000 and 2000.

9. Calculate the overhead per computer for a Cortland 1000 and a Cortland 2000.

10. Calculate the manufacturing cost of ONE Cortland 1000 and ONE Cortland 2000 using ABC overhead allocation.

11. Show how the company would determine a selling price for each model under the ABC system.

12. Should Mr. Works adopt an ABC system for internal analysis? Your answer should address the question very specifically to this case – no generalities about ABC from the book. It should contain two points in favor of ABC, and two drawbacks that he should be aware of.  

13. Mr. Works is also concerned about future product development. They have several new models under development at this time. If an ABC system is used, list two characteristics of a new model that will make it more costly to manufacture.

Answer 1

There are 3 kinds of machines being used by the company. They are Inspecting Machines, Soldering Machines and Assembly machines.

Total no. of machine hours = Inspecting Machine Hours + Soldering Machine hours + Assembly Machine Hours

= 200,000 + 200,000 + 100,000

= 500,000 machine hours.

Question 1:

Predetermined Overhead Rate the company is currently using:

Budgeted Manufacturing Overhead = $196,000,000

Machine hours = 500,000

Overhead Rate = $196,000,000 500,000 = $392 per machine hour.

Question 2:

Manufacturing Cost of One Cortland 1000 and One Cortland 2000:

Machine hours used by ONE computer is as follows:

Therefore, Manufacturing cost of ONE Cortland 1000 computer is $3,160 and ONE Cortland 2000 computer is $4,468.

Question - 3:

Selling Price of ONE Cortland 1000 and ONE Cortland 2000 is as follows:

Question 4:

Raw Material order for each model:

Cortland 1000:

Number of Computers = 20,000

Order Size = 10,000

No. or order received = 20,000 10,000 = 2 orders

Cortland 2000:

Number of Computers = 5,000

Size of Order = 500

No. or order received = 5,000 500 = 10 orders

Question 5:

Number of batches of each model the company pack and ship:

Cortland 1000:

Number of Computers expected to be sold = 20,000

Batch Size = 5,000

No. or batches packed and shipped = 20,000 5,000 = 4 batches

Cortland 2000:

Number of Computers = 5,000

Batch Size = 100

No. or batches packed and shipped = 5,000 100 = 50 batches