Activity Based Costing Project Autotech Manufacturing Product Costs Autotech Manufacturing is engaged in the production of replacement parts for automobiles. One plant specializes in the production of two parts: Part 127 and Part 234. Part 127 produces the highest volume of activity, and for many years it was the only part produced by the plant. Five years ago, Part 234 was added. Part 234 was more difficult to manufacture and required special tooling and setups. Profits increased for the first three years after the addition of the new product. In the past two years, however, the plant has faced intense competition, and its sales of Part 127 have dropped. In fact, the plant showed a small loss in the most recent reporting period. Much of the competition was from foreign sources, and the plant manager was convinced that the foreign producers were guilty of selling the part below the cost of producing it. The following conversation between Patty Goodson, plant manager, and Joseph Fielding divisional marketing manager, reflects the concerns of the division about the future of the plant and its products. Joseph: You know, Patty, the divisional manager is really concerned about the plant's trend. He indicated that in this budgetary environment, we can't afford to carry plants that don't show a profit. We shut one down just last month because it couldn't handle the competition. Patty: Joe, you and I both know that Part 127 has a reputation for quality and value. It has been a mainstay for years. I don't understand what's happening. Joseph: I just received a call from one of our major customers concerning Part 127. He said that a sales representative from another firm offered the part at $20 per unit-- $11 less than what we charge. It's hard to compete with a price like that. Perhaps the plant is simply obsolete. Patty: No. I don't buy that. From my sources, I know we have good technology. We are efficient. And it's costing a little more than $21 to produce that part. I don't see how these companies can afford to sell it so cheaply. I'm not convinced that we should meet the price. Perhaps a better strategy is to emphasize producing and selling more of Part 234. Our margin is high on this product, and we have virtually no competition for it. Joseph: You may be right. I think we can increase the price significantly and not loose business. I called a few customers to see how they would react to a 25 percent increase in price, and they all said that they would still purchase the same quantity as before. Patty: It sounds promising. However, before we make a major commitment to Part 234, I think we had better explore other possible explanations. I want to know how our production costs compare with those of our competitors. Perhaps we could be more efficient and find a way to earn our normal return on Part 127. The market is so much bigger for this part. I'm not sure we can survive with only Part 234. Besides, my production people hate that part. It's very difficult to produce. After her meeting with Joseph, Patty requested an investigation of the production costs and comparative efficiency. She received approval to hire Sergeant Consulting Group to make an independent investigation. The staff accountant for Sergeant Consulting Group has uncovered the following costs and activities associated with the two products. Part 127 Production Selling Price 500,000 $31.86 Prime costs per unit $9.53 Number of production runs 100 Receiving orders 400 Machine hours 125,000 Direct labor hours 250,000 5,000 500 Part 234 100,000 $24.00 $8.26 200 1,000 60,000 22,500 5,000 400 Engineering hours Material moves Overhead is allocated using a plant-wide rage based on direct labor hours. Preliminary analysis of costs by Sergeant Consulting Group revealed that similar costs can be categorized into the following cost pools. Setup costs are costs that occur each time a new production run is made. They involve retooling and reconfiguring the machines and technology. Material handling costs include the equipment and personnel required to transport materials from supplier trucks to the machines. Typically, materials are taken to a storage area before being transported to machines. Each production run will need new materials and materials may also be transported during production runs. Machine costs primarily include depreciation and machine maintenance. Although the machines are depreciated using accelerated depreciation schedules, typically the machine wear out from use and are replaced before they become obsolete. Receiving costs include the costs of clerical and technical help associated with the processing of each order received from a customer. Engineering costs include the technical support staff that implement design changes in the part, manage processes to maintain quality, and provide technical information on the product. The engineering staff maintain a record of the amount of time spent on each product. General plant costs include all the other administrative costs not included in the other cost pools. Overhead Cost Pools Setup costs Material handling costs Machine costs Receiving costs Engineering costs $240,000 900,000 1,750,000 2,100,000 1,500,000 General plant costs Total 500,000 $6,990,000 You are to assume you are a consultant working for the company. You will want your report to be professional and "ADD VALUE" to the company. Use an executive summary, followed by the detailed report. Be sure to include the following: (1) Argue for the use of Activity-based Costing by in this case by: a) Describing when Activity-based Costing is appropriate and when Traditional Costing is appropriate and when each is not appropriate to use. b) Discussing what are the strengths and weaknesses of ABC? When is it appropriate to use? What kinds of business situations suggest the need for ABC? c) Applying a &b to the case and arguing for an Activity-based Costing system. (2) Describe the Activity-based costing system you are recommending. Include a justification for the cost driver selected. (3) Present your new cost findings. Include both per unit and total cost data. There should be tables with cost information included. (4) Make strategy recommendations for each product and for the plant. Use the cost and profit numbers to justify these recommendations. (5) Comment on the validity of the plant manager's concern that competitors are selling below the cost of making Part 127. (6) Explain the apparent lack of competition for Part 234 and the customers' response to potential price increase. (7) Make any other additional recommendations or suggestions