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 pre- mium 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 dene 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 satised 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 prot performance has been declin- ing. 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 signicant 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 prot 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 compa- rable 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 regain most of our lost market share. But we also need to make sure that the quality of our products meets that of our competi- tors. As you know, we are spending a lot of money each month on rework and warranties. That worries me. Id like to see that warranty cost cut by 70 to 80 percent. If we could do that, then customers would be more satised 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 protability. I think we need to improve our cost accounting system. I am not condent 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 over- costed, 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 infor- mationinformation 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 resour- ces. 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, nd 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.

TO: Kim Breashears

FROM: Jacob Carder

SUBJECT: Preliminary Analysis

MEMO

Based on my initial analysis, I am condent that an ABC system will offer signicant 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 infor- mation 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 signicant cost; from production reports, she also knew that the rework activity involved signif- icant 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

Assume that the quality control manager implements a program that reduces the number of defective units by 50 per- cent. Because of the improved quality, the demand for inspection hours will also drop by 50 per- cent. What is the potential monthly reduction in inspection costs?