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 a large plant in Ohio. 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; arn 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 EnhancedPremium Sales (units) Price per unit Unit costs 50,000 500,000 300,000 $40 $16 $30 Driver traced Allocated Directly attributable $3 $2 $10 S5 $4 $13 $7 $6 $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. March's 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. March's dismal performance was also typical for what has be -unless some action by management is taken to reverse the trend. During March, the phone division reported the tollowing results en happening this year and is expected to continue Inventories: Materials, March 1 Materials, March 31 Work in process, March 1 Work in process, March 31 Finished goods, March 1 Finished goods, March 31 S 23,000 40,000 130,000 45,000 480,000 375,000 Costs Direct labor Plant and equipment depreciation 50,000 Material handling Inspections Scheduling Power Plant supervision Manufacturing engineering $117,000 85,000 60,000 30,000 30,000 12,000 21,000 Sales commissions 120,000 10,000 17,000 40,000 30,000 alary, sales supervisor Supplies Warranty work Rework 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. CTB's Phone Division had sales totaling $1,170,000 for March. Based on March's results, Bryce decided to meet with three of the Phone Division's managers; Kim Breashears, divisional manager; Jacob Carder, divisional controller; and Larry Hartley, sales manager. A transcript of their recorded conversation is given next: Bryce: "March's profit performance is down once again, and I think we need to see if we can identify the problem and correct it-before it's too late. Kim, what's 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. I've 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: "They're right. If we could lower our prices by 10 to 15 percent, I think that we'd regain most of our lost market share. But we also need to make 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 worries me. I'd like to see that warranty cost cut by 70 to 80 percent. If we could do that, then customers would be more 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 promising-especially if the overcosting is for some of our high-volume lines. A price decrease for these products would make the biggest difference-and 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 trace-or attempt to trace-overhead 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 don't 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 nonunit-based drivers add anything. Activity-based management is not an inexpensive undertaking. So I suggest that we doa preliminary study to see if direct labor cost is adequate for tracing. If not, then maybe some nonunit 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? It's 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. I'll 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 Kim Breashears TO: FROM: -Jacob Carder SUBJECT: Preliminary Analysis Based on my initial analysis, I am confident that an ABC system will offer significant improvement. I regressed total monthly overhead cost on monthly direct labor cost using the following 15 months of data: Overhead Direct Labor Cost S360,000 $110,000 300,000 350,000 400,000 320,000 380,000 300,000 280,000 340,000 410,000 375,000 360,000 340,000 330,000 300,000 100,000 90,000 100,000 90,000 100,000 90,000 90,000 95,000 115,000 100,000 85,000 85,000 90,000 80,000 The results were revealing. Although direct labor cost appears to be a driver of overhead cost, it really doesn't explain a lot of the variation. I then searched for other drivers-particularly nonunit drivers that might offer more insight into overhead cost behavior. Every time a batch is produced, material 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 Formula two, materials handling cost and number of moves Comment on Jacob Carder's observations concerning the outcomes