CASE ASSIGNMENT #1: Cortland Manufacturing, Inc.

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 Im not so sure.

Steve Works, CEO, Cortland Manufacturing, Inc. (CMI)

Steves 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 dont even know where to start! I never dreamed that some day my career would come to this. I wish Id paid more attention to those classes so I could understand what is going on here. Im 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 CMIs 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 CMIs 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 companys 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 companys 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 dont 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 didnt really. Even though we cannot at this point change prices for 2010, we at least need to know if were covering full production cost on the Cortland 2000 and have something left to contribute to the companys selling, general and administrative expenses. I thought this was so, but now well, Im not so sure. Wed better figure this out before we begin our budget cycle for 2011. Maybe I need to go back to school!

CORTLAND MANUFACTURING COMPANY Exhibit 1. Direct Manufacturing Costs for One Computer Cortland 1000 Cortland 2000 Raw (direct) material $1,000 $2,500 Direct labor $200 $400 Exhibit 2. Analysis of Annual Budgeted Manufacturing Overhead Costs Activity Raw material handling Machine adjusting Packing Raw material inspecting Soldering Assembly Cost Driver Received orders Setups Batches Inspecting hours Soldering hours Assembly hours Budgeted Activity Budgeted Cost 200 $90,000,000 2,000 12,000,000 500 60,000,000 200,000 10,000,000 200,000 12,000,000 100,000 12,000,000 Total $196,000,000 Exhibit 3. Annual Production Data for Cortland 1000 and Cortland 2000 Computers Item Measure Cortland 1000 Cortland 2000 Budgeted production no. of computers 20,000 5,000 Received order size* size of order 10,000 500 Batch size computers 5,000 Machine setups per batch Inspecting time hours per computer Soldering time hours per computer Assembly time hours per computer 100 * The company received 2 orders of raw materials each year for the Cortland 1000 (i.e., 20,000 computers = 10,000 order size) Determine the full product cost and selling prices of one Cortland 1000 and one Cortland 2000 under the current product costing system. How would these costs change under an activity-based costing system? CORTLAND MANUFACTURING COMPANY Exhibit 1. Direct Manufacturing Costs for One Computer Cortland 1000 Cortland 2000 Raw (direct) material $1,000 $2,500 Direct labor $200 $400 Exhibit 2. Analysis of Annual Budgeted Manufacturing Overhead Costs Activity Raw material handling Machine adjusting Packing Raw material inspecting Soldering Assembly Cost Driver Received orders Setups Batches Inspecting hours Soldering hours Assembly hours Budgeted Activity Budgeted Cost 200 $90,000,000 2,000 12,000,000 500 60,000,000 200,000 10,000,000 200,000 12,000,000 100,000 12,000,000 Total $196,000,000 Exhibit 3. Annual Production Data for Cortland 1000 and Cortland 2000 Computers Item Measure Cortland 1000 Cortland 2000 Budgeted production no. of computers 20,000 5,000 Received order size* size of order 10,000 500 Batch size computers 5,000 Machine setups per batch Inspecting time hours per computer Soldering time hours per computer Assembly time hours per computer 100 * The company received 2 orders of raw materials each year for the Cortland 1000 (i.e., 20,000 computers = 10,000 order size) Determine the full product cost and selling prices of one Cortland 1000 and one Cortland 2000 under the current product costing system. How would these costs change under an activity-based costing system