CableTech Bell Corporation (CTB) operates in the telecommunications industry. CTB has two divisions: the Phone Division and the Cable Service Division. The Phone Division manufactures telephones in several plants located in the Midwest. The product lines run from relatively inexpensive touch-tone wall and desk phones to expensive, high-quality cellular phones. CTB also operates a cable TV service in Ohio. The Cable Service Division offers three products: a basic package with 25 channels; an enhanced package, which is the basic package plus 15 additional channels and two movie channels; and a premium package, which is the basic package plus 25 additional channels and three movie channels.

The Cable Service Division reported the following activity for the month of March:

	Basic			Enhanced			Premium
Sales (units)		50,000			500,000			300,000
Price per unit		$16			$30			$40
Unit costs:
Directly traced		$3			$5			$7
Driver traced		$2			$4			$6
Allocated		$10			$13			$15

The unit costs are divided as follows: 70 percent production and 30 percent marketing and customer service. Direct labor cost is the only driver used for tracing. Typically, the division uses only production costs to define unit costs. The preceding unit product cost information was provided at the request of the marketing manager and was the result of a special study.

Bryce Youngers, the president of CTB, is reasonably satisfied with the performance of the Cable Service Division. Marchs performance is fairly typical of what has been happening over the past two years. The Phone Division, however, is another matter. Its overall profit performance has been declining. Two years ago, income before income taxes had been about 25 percent of sales. Marchs dismal performance was also typical for what has been happening this year and is expected to continue unless some action by management is taken to reverse the trend. During March, the Phone Division reported the following results:

Inventories:
Materials, March 1	$23,000
Materials, March 31	40,000
Work in process, March 1	130,000
Work in process, March 31	45,000
Finished goods, March 1	480,000
Finished goods, March 31	375,000
Costs:
Direct labor	$117,000
Plant and equipment depreciation	50,000
Materials handling	85,000
Inspections	60,000
Scheduling	30,000
Power	30,000
Plant supervision	12,000
Manufacturing engineering	21,000
Sales commissions	120,000
Salary, sales supervisor	10,000
Supplies	17,000
Warranty work	40,000
Rework	30,000

During March, the Phone Division purchased materials totaling $312,000. There are no significant inventories of supplies (beginning or ending). Supplies are accounted for separately from materials. CTBs Phone Division had sales totaling $1,170,000 for March.

Based on Marchs results, Bryce decided to meet with three of the Phone Divisions managers: Kim Breashears, divisional manager; Jacob Carder, divisional controller; and Larry Hartley, sales manager. A transcript of their recorded conversation is given next:

Bryce: Marchs profit performance is down once again, and I think we need to see if we can identify the problem and correct itbefore its too late. Kim, whats your assessment of the situation?

Kim: Foreign competition is eating us alive. They are coming in with lower-priced phones of comparable or higher quality than our own. Ive talked with several of the retailers that carry our lines, and they say the same. They are convinced that we can sell more if we lower our prices.

Larry: Theyre right. If we could lower our prices by 10 to 15 percent, I think that wed regainmost of our lost market share. But we also need tomake sure that the quality of our products meets that of our competitors. As you know, we are spending a lot of money each month on rework and warranties. That worriesme. Id like to see that warranty cost cut by 70 to 80 percent. If we could do that, then customers would bemore satisfied with our products, and I bet that we would not only regain our market share but increase it.

Jacob: Lowering prices without lowering per-unit costs will not help us increase our profitability. I think we need to improve our cost accounting system. I am not confident that we really know how much each of our product lines is costing us. It may be that we are overpricing some of our units because we are overcosting them. We may be underpricing other units.

Larry: This sounds promisingespecially if the overcosting is for some of our high-volume lines. A price decrease for these products would make the biggest differenceand if we knew they were overcosted, then we could offer immediate price reductions.

Bryce: Jacob, I need more explanation. We have been using the same cost accounting system for the last 10 years. Why would it be a problem?

Jacob: I think that our manufacturing environment has changed. Over the years, we have added a lot of different product lines. Some of these products make very different demands on our manufacturing overhead resources. We traceor attempt to traceoverhead costs to the different products using direct labor cost, a unit-based cost driver. We may be doing more allocation than tracing. If so, then we probably dont have a very good idea of our actual product costs. Also, as you know, with the way computer technology has changed over time, it is easier and cheaper to collect and use detailed information information that will allow us to assign costs more accurately.

Bryce: This may be something we should explore. Jacob, what do you suggest?

Jacob: If we want more accurate product costs and if we really want to get in the cost reduction business, then we need to understand how costs behave. In particular, we need to understand activity cost behavior. Knowing what activities we perform, why we perform them, and how well we perform them will help us identify areas for improvement. We also need to know how the different products consume activity resources. What this boils down to is the need to use an activity-based management system. But before we jump into this, we need some idea of whether non-unit-based drivers add anything. Activity-based management is not an inexpensive undertaking. So I suggest that we do a preliminary study to see if direct labor cost is adequate for tracing. If not, then maybe some non-unit-drivers might be needed. In fact, if you would like, I can gather some data that will provide some evidence on the usefulness of the activity-based approach.

Bryce: What do you think, Kim? Its your division.

Kim: What Jacob has said sounds promising. I think he should pursue it and do so quickly. I also think that we need to look at improving our quality. It sounds like we have a problem there. If quality could be improved, then our costs will drop. Ill talk to our quality people. Jacob, in the meantime, find out for us if moving to an activity-based system is the way to go. How much time do you need?

Jacob: I have already been gathering data. I could probably have a report within two weeks.

MEMO
TO:	Kim Breashears
FROM:	Jacob Carder
SUBJECT:	Preliminary Analysis

Based on my initial analysis, I am confident that an ABC system will offer significant improvement. For one of our conventional phone plants, I regressed total monthly overhead cost on monthly direct labor cost using the following 15 months of data:

	Overhead			Direct Labor Cost
	$360,000				$110,000
	300,000				100,000
	350,000				90,000
	400,000				100,000
	320,000				90,000
	380,000				100,000
	300,000				90,000
	280,000				90,000
	340,000				95,000
	410,000				115,000
	375,000				100,000
	360,000				85,000
	340,000				85,000
	330,000				90,000
	300,000				80,000

The results were revealing. Although direct labor cost appears to be a driver of overhead cost, it really doesnt explain a lot of the variation. I then searched for other driversparticularly non-unit drivers that might offer more insight into overhead cost behavior. Every time a batch is produced, material movement occurs, regardless of the size of the batch. The number of moves seemed like a more logical driver. I was able to gather only 10 months of data for this. (Our information system doesnt provide the number of moves, so I had to build the data set by interviewing production personnel.) This information is provided next:

Materials-Handling Cost		Number of Moves
$80,000			1,500
60,000			1,000
70,000			1,250
72,000			1,300
65,000			1,100
85,000			1,700
67,000			1,200
73,500			1,350
83,000			1,400
84,000			1,700

The regression results were impressive. There is no question in my mind that the number of moves is a good driver of materials-handling costs. Using the number of moves to assign materials-handling costs to products would likely be better than the cost assignment using direct labor cost. Furthermore, since small batches use the same number of moves as large batches, we have some evidence that we may be overcosting our high-volume products.

I looked at one more overhead activity: inspecting products. We have 15 inspectors who are paid an average of $4,000 per month. Each inspector offers about 160 hours of inspection capacity per month. However, it appears that they actually work only about 80 percent of those hours. The drop in demand we have experienced explains this idle time. I see no evidence of variable cost behavior here. Im not exactly sure how to treat inspection cost, but I think that it is more related to inspection hours than direct labor cost. Some of the other overhead activities seem to be non-unit-level, as well enough, in fact, to be concerned about how we assign costs.

After receiving the memo, Kim was intrigued. She then asked Jacob to use the same phone plant as a pilot for a preliminary ABC analysis. She instructed him to assign all overhead costs to the plants two products (Regular and Deluxe models), using only four activities. The four activities were rework, moving materials, inspecting products, and a general catch-all activity labeled other manufacturing activities. From the special study already performed, she knew that materials handling and inspecting involved significant cost; from production reports, she also knew that the rework activity involved significant cost. If the ABC and unit-based cost assignments did not differ by breaking out these three major activities, then ABC may not matter.

Pursuant to the request, Jacob produced the following cost and driver information:

Activity	Expected Cost				Driver		Activity Capacity
Other activities		$2,000,000			Direct labor dollars			$1,250,000
Moving materials		900,000			Number of moves			18,000
Inspecting		720,000			Inspection hours			24,000
Reworking		380,000			Rework hours			3,800
Total overhead cost		$4,000,000

Expected activity demands:

	Regular Model			Deluxe Model
Units completed		100,000			40,000
Direct labor dollars		$875,000			$375,000
Number of moves		7,200			10,800
Inspection hours		6,000			18,000
Rework hours		1,900			1,900

Required:

1. Compute two different unit costs for each of the Cable Service Divisions products. What managerial objectives are being served by these unit cost computations? Round the answers to two decimal places.

	Basic			Enhanced			Premium
Method I		$			$			$
Method II

Method I costs include all production, marketing, and customer service costs. There may be, and very likely is, very little R&D function in the Cable Service Division. Thus, this first unit cost could satisfy both value-chain and operating cost definitions. The objectives include pricing decisions, product mix decisions, and strategic and tactical profitability analysis. Method I costs include only production costs; complying with external financial reporting guidelines is the primary managerial objective of this method.

2. Three different cost categories are provided by the Cable Service Division: direct tracing, driver tracing, and allocation. Discuss the meaning of each. Based on how costs are assigned, do you think that the Cable Service Division is using a functional-based or an activity-based cost accounting system? What other differences exist between functional-based and activity-based cost accounting systems?

Direct tracing is a cost assignment method that relies on physically observable causal relationships to assign costs to cost objects. Driver tracing relies on causal factors called drivers to assign costs to cost objects. Allocation relies on assumed linkages or convenience (ease of use) to assign cost to cost objects. The cost assignment approach used by the Cable Service Division appears to beallocation . No non-unit-level drivers are being used to assign costs. Apparently, the usual and only product cost definition provided by the accounting system is based on production costs. Other variants such as the one provided are obtained only by special efforts. This provides evidence that the division is using a functional-based cost accounting system. Other differences that distinguish the two systems (but are not mentioned) are the presence or absence of detailed activity information, whether activities or costs are the focus, whether the emphasis is on local or system wide performance measurement, and the use (or nonuse) of nonfinancial performance measures.

3. Discuss the differences between the Cable Service Divisions products and the Phone Divisions products.

The two divisions differ based on the nature of their output Telephones are tangible products, and cable services are intangible products. Tangible products are produced by converting materials through the use of labor and other inputs such as plant, land, and machinery. Services are tasks or activities performed for a customer or an activity performed by a customer using an organizations products or facilities. Cable service differs from telephones in that cable services are intangible and perishable (cannot be inventoried). Phones can be felt, seen, and stored. Cable services cannot.

4. Prepare an income statement for the Cable Service Division for March.

Cable Service Division
Income Statement
For the Month of March
Sales revenue	$
Cost of services sold
Gross margin	$
Less: Operating expenses
Income before income taxes	$

Feedback

Correct

5a. Prepare the cost of goods manufactured statement for the Phone Division for March.

Phone Division
Statement of Cost of Goods Manufactured
For the Month of March
Direct materials:
Beginning inventory	$
Add: Purchases
Materials available	$
Direct materials used		$
Direct labor
Overhead:
	$
Total manufacturing costs added:		$
Cost of goods manufactured		$

Feedback

Partially correct

5b. Prepare an income statement for the Phone Division for March.

Phone Division
Income Statement
For the Month of March
		$
Cost of goods sold:
	$
Goods available for sale	$
		$
		$

Feedback

Incorrect

6. The Phone Division has been using the same cost accounting system for over 10 years. Explain why its cost accounting system may be outmoded. What factors determine when a new cost accounting system is warranted?

The Phone Division has added a number of different products over the years. The different products seem to consume overhead resources in different proportions. There is some belief that using only unit-based drivers is inadequate for assigning overhead costs. Furthermore, 10 years have passed since the current cost accounting system was adopted, information processing technology has advanced, and it is cheaper to operate more sophisticated cost accounting systems. Also, if the current system is overcosting the high-volume products as suggested, then bad pricing decisions are being made that could be very costly for the companyespecially considering the increased competition. Decreased measurement costs and increased error costs are the major factors signaling the obsolescence of the current system and the need for a new system. For CTB, measurement costs have likely decreased. Evidence indicates that there may be bad cost assignments, and the cost of bad decisions has gone up. Taken together, a new system seems justified.

7. Using the method of least squares, calculate two cost formulas: one for overhead using direct labor cost as the driver, and one for materials handling cost using number of moves as the driver. Round the intercept to the nearest dollar and round the slope to the nearest cent.

Formula one, overhead and direct labor cost: Y = $ + $ X

Formula two, materials handling cost and number of moves: Y = $ + $ X

Comment on Jacob Carders observations concerning the outcomes.

Jacobs comments seem to be on target. Direct labor cost explains less than 40 percent of the variability in overhead costnot enough to justify using Direct labor cost as the only driver to trace overhead to individual products. The number of moves a non-unit driver, explains 90 percent of the materials-handling cost variability. Using the number of moves to assign materials-handling cost appears reasonable and certainly better than using direct labor cost to assign this cost. In fact, since small batches use the same moves as large batches but much less labor, then large batches are receiving too much materials-handling cost. Thus, some evidence exists that high-volume products are overcosted .

8. How would you describe the cost behavior of the inspection activity? Assume that the quality control manager implements a program that reduces the number of defective units by 50 percent. Because of the improved quality, the demand for inspection hours will also drop by 50 percent. What is the potential monthly reduction in inspection costs? How did knowledge of inspections cost behavior help?

Inspection activity follows a step-cost function, with each step being defined by hours per year. Each step costs $. Current total activity capacity is hours. Current demand for the activity is hours. If the demand drops by 50 percent, then the new demand would be hours. Unused capacity at this point will be hours. Thus, $ can be saved per month.

9. Calulate the overhead cost per unit for each phone model using direct labor cost to assign all overhead costs to products.

	Overhead Cost per Unit
Regular	$
Deluxe	$

10. Calculate the overhead cost per unit using the four activities and drivers identified by Kim and Jacob. If you were Kim, would you be inclined to implement an ABC system based on the evidence from this pilot test? If required, round the answers to two decimal place.

	Activity Rates
Other:			per direct labor dollar
Moving:		$	per move
Inspecting:		$	per inspection hour
Reworking:		$	per rework hour

	Unit Cost
Regular	$
Deluxe	$

The cost per unit is much different based on the ABC assignments suggesting that improved accuracy can make a significant difference in managerial decision making. The evidence is supportive of implementing ABC.

11. Suppose someone urged Kim to look into Time-Driven Activity-Based Costing (TDABC) instead of ABC. What would be the advantages of using a TDABC aproach?

Simple to implement

Easy to update and maintain

Ability to use time equations that easily capture what are essentially multiple activities

It is possible to have a more granular model without the associated expense.

All of the above