Question

MANAGERIAL ACCOUNTING CASE STUDY.

CASE ASSIGNMENT #1: Cortland Manufacturing, Inc.

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. TheCortland 1000 is a very popular computer with a large production and sales volume. By contrast, theCortland 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

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: 20,000computers per year, divided by 10,000 computers each order will build = 2 orders per year.

*Questions*

1. Determine the full product cost and selling prices of one Cortland 1000 and one Cortland 2000 under the current product costing system. How would these costs change under an activity-based costing system?

2. What are the reasons for the differences between the two systems? More generally, what are the characteristics of a computer whose manufacturing cost will increase under the product costing system being proposed by the accountant? Please be specific.

3. What should Mr. Works do?

PS: I need to write a 10 page paper on these three questions, so please be very detailed, Thank you.

Answer 1

Answer
1	(i) Product Costing
	A	Product cost and selling price of Cartland 1000 and Cartland 2000
		Sl No	Particulars	Cartland 1000($)	Cartland 2000($)
		1	Direct Material	1000	2500
		2	Direct Labour	200	400
		3	Direct costs (1+2)	1200	2900
		4	Overheads	4356	3484
		5	Total product cost(3+4)	5556	6384
		6	Markup (5*50%)	2778	3192
		7	Selling price (5+6)	8333	9577
	(ii) Activity based costing system
	A	Activities
		Sl No	Activity	Cost driver	Budgeted activity (for entire company)	Budgeted cost
		1	Receive/handle raw material	Orders received	200 orders	$9,00,00,000
		2	Adjust/set up machines	Number of setups	2,000 setups	$1,20,00,000
		3	Inspect, pack, ship computers	Batches	500 batches	$6,00,00,000
		4	Inspect raw materials	Inspection hours	200,000 insp. hr.	$1,00,00,000
		5	Solder parts	Soldering hours	200,000 sdr. hr.	$1,20,00,000
		6	Assemble computers	Assembly hours	100,000 assm. hr.	$1,20,00,000
	B	Production Data for Cortland 1000 and Cortland 2,000 Computers Item
		Sl No	Item	Measure	Cortland 1000	Cortland 2000
		1	Budgeted production	Number of computers	20,000	5,000
		2	Received order size*	Size of order	10,000	500
		3	Batch size	Number of computers	5,000	100
		4	Machine setups	Number of s/u per batch	5	6
		5	Inspecting time (Raw mat.)	Hrs/com	1	2
		6	Soldering time	Hrs/com	3	1
		7	Assembly time	Hrs/com	1	1
	C	Calculation of No of Orders and Batches (#)
		Sl No	Item		Cortland 1000	Cortland 2000
		1	Budgeted production		20,000	5,000
		2	Received order size*		10,000	500
		3	Batch size		5,000	100
		4	No of orders	(Production/order size)	2	10
		5	No of batches	(Production/Batch size)	4	50
	D	Allocation of production overhead under Activity Based Costing
		Sl No	Budgeted cost	Ratio (Refer piont #C)	Cartland 1000($)	Cartland 2000($)
		1	90000000	2:10	1,50,00,000	7,50,00,000
		2	12000000	5:6	54,54,545	65,45,455
		3	60000000	4:50	44,44,444	5,55,55,556
		4	10000000	1:2	33,33,333	66,66,667
		5	12000000	3:2	72,00,000	48,00,000
		6	12000000	1:1	60,00,000	60,00,000
			196000000		4,14,32,323	15,45,67,677
	D	Determination of per unit product cost and selling price of Cartlan 1000 and cartland 2000 (Activity based costing)
		Sl No	Particulars	Cartland 1000($)	Cartland 2000($)
		1	Direct Material	1000	2500
		2	Direct Labour	200	400
		3	Direct costs (1+2)	1200	2900
		4	Overheads (Overhead cost/No of units)	2072	30914
		5	Total product cost(3+4)	3272	33814
		6	Markup (5*50%)	1636	16907
		7	Selling price (5+6)	4907	50720
2	Reasons for differences in two costing systems
	The traditional Product Costing System doesn’t allocates manufacturing overheads to the correct product.
	Because, activity that drives the cost has not been taken into consideration by this consting.
	Where as, activity based costing system taken in to account the cost drivers.
	Overhead costs will be allocated to respective cost driver taking the appropriate ratio.
	This system will ensure that the product cost is properly prepared.
3	What should Mr. Works do
	Since the traditional product costing system shows Cortland 2000 selling price @ $ 9577, which is not correct.
	Based on activity based costing system, the cost of production of Cortland 2000 is $ 50570, much higher than the cost arrived under previous costing method.
	Therefore Mr. Works and team shall go for activity based costing for the products. Shall discontinue the production of Cartlant 2000.