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

Uses a new processing chip imported from Sweden.

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

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.

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

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

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

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?

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

How many machine setups does Cortland do for each model?

Calculate a rate for each activity in Exhibit 2.

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

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

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

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

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.

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

Note

The case does not mention the question number properly so I gave you a detailed answer with all equations and explanation. for any doubts commend, please. Because the question is a bit confusing in nature but having superb quality.

Computation of Cost under traditional Method

Cost Category	Cortland 1000($)	Cortland 2000 ($)
Direct Material	1,000	2,500
Direct Labor	200	400
Manufacturing Overhead	653	1,307
Total Cost	1,853	4,207

Computation of Price under Traditional Method

	Cortland 1000($)	Cortland 2000 ($)
Cost per unit	1,853	4,207
Markup per unit	926.50	2,103.5
Selling price	2,779.5	6,310.5

Activity Based Cost Computation

Activity	Budgeted Activity(For the entire company)	Budgeted Cost($)	Cost /Activity($)
Receive/handle raw Material	200 order	90,000,000	450,000
Adjust Setup Machine	2000 Setup	12,000,000	6,000
Inspect pack ship computer	500 batches	60,000,000	120,000
Inspect raw material	200,000 hrs	10,000,000	50
Solder parts	200,000 hrs	12,000,000	60
Assemble Computer	100,000 hrs	12,000,000	120

Per unit overhead cost computation ABC

Activity	Cortland 1000	Cortland 2000
Receive handle raw material cost (Cost /order*Number of order)/ the number of units in order. Number of order =Budgeted Products /Order size)	$45 ($450000*2)/20000 (20000/10000) =2	$900 ($450000*10)/5000 (5000/500) =10
Adjust setup cost (Cost per setup/*set up/batch)/batch size	$6 ($6000*50/5000	$360 ($6000*6)/100
Inspect pack (Cost per batch/batch size)	$24 ($120000/5000)	$1200 ($120000/100)
Inspecting time (per hr cost *hrs used)	$50 ($50*1)	$100 ($50*2)
Soldering timing ((per hr cost *hrs used)	$180 ($60*3)	$60 ($60*1)
Assembly (per hr cost *hrs used)	$120 ($120*1)	$120 ($120*1)
	$425	$2740

Per unit Cost Computation under ABC

Cost Category	Cortland 1000($)	Cortland 2000($0
Direct Material	1,000	2,500
Direct Labor	200	400
Manufacturing OVERHEAD	425	2,740
Total Cost	1,625	5,640

Computation of Selling price Under ABC Method

	Cortland 1000($)	Cortland 2000 ($)
Cost Per unit	1,625	5,620
Markup per unit	812.5	2,810
Selling price	2,437.5	8,430

According to me, the company should use ABC System due to the following.

1. It should give weightage to the cost driver so exact cost can be allocated.
2. It will avoid over cost absorption by product line.

It has the following drawback too.

1.it should be done by efficient professional otherwise it will give a highly deviated result.

2. Sometimes the cost driver selected May not be appropriate