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.