CASE STUDY

When our old cost system was designed and implemented, it was state-of-that-art. But it no longer provided us with accurate numbers. The reported numbers were too aggregated to provide us with accurate numbers. The reported numbers were too aggregated to provide direct feedback on the performance of shop floor worker.

Mr. Miller, Controller: Powerhugs

Powerhugs - History and Products

Powerhugs, located in Naringin, was founded in 1924 as the Schnitzler Werke company. Initially it produced hand drills, and subsequently expanded its product line into hand and electric tools for craftsmen, eventually offering the world's largest do-it-yourself product line of hand-operated power tools. The company is still controlled by the three founding families (Class, Rauch, and Schnitzler) though in 1978 its legal status was changed to that of a limited partnership with a limited company as general partner.

Powerhugs today produces a full line of power tools including saws, rotary and impact drills, screwdrivers, hammers, grinders, polishers, planers, and routers. Products are sold to do-it-yourselfers, professionals, and industrial workers. In addition to hand tools, Powerhugs manufactures bench and column mounted drilling machines, belt polishing and buffing machines, and grinding machines. Altogether, Powerhugs produces 500 basic and about 2,000 different final products. The company manufactures 45,000 'standard' parts plus customer specified products. About 85-90% of turnover occurs in standard products, the remainder in special orders. All products are developed internally.

Powerhugs is considered the Rolls-Royce of the hand-tool industry and has been able to command a price premium compared to its competition. The company's main competitors, also offering full product lines, are Bosch and AEG, two West-Naringin manufacturers, and Black & Decker. Bosch, the market leader, and AEG, the number two, offer good quality, good image, and slightly lower prices. Black & Decker competes in the lower end of the market. Recently Japanese competitors have entered Powerhugs' home market. While they offer good quality and lower prices, they lack Powerhugs' full product line.

The Production Process

Despite being a relatively small company, Powerhugs is completely vertically integrated and builds all critical components and sub-assemblies in house. One of the company's founders believed, 'You get quality only if you do it yourself'.

Power tool production starts with raw material treatment, including components made in the aluminium foundry, by plastic injection moulding, and in steel treatment. About three metric tons of aluminium are melted daily in the foundry and cast into various small components that are subsequently cleaned, polished and inspected. In the plastic injection moulding department, granular material is fed from large storage silos into various machines to be heated and injected under pressure into moulds to form plastic components (e.g., handles) for the hand tools. The moulding machines come in different sizes and have different manpower requirements, ranging from 1 operator for 1 machine to 1 operator for 6 machines. Steel treatment produces machined parts such as wheels, chucks and armature shafts. Two types of treatment occur: bar feeding, where treated bars are cui after treatment, and piece feeding, where pre- cut parts are machined. Because of the considerable diversity of parts (about 1,500) processed through steel treatment, a large inventory of 1,000 to 1,200 metric tons of steel, worth about $900,000, is maintained for the area.

In the bar feeding process, the steel bars are taken by crane to the appropriate turning machine for processing. Two types of turning machines are used: 6-spindle machines which process 6 steel bars simultaneously and single-spindle machines. About 1,000 different parts are produced in this department - 60% on the 6-spindle machines. Set-up times depend on the dimensions of the components. Components with similar specifications might require only minor

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adjustments to the machines. If the components are completely different, set-up times can range between 2 and 14 hours, even with extensive preparation work performed while the previous part is running on the machine. Twelve set-up people work exclusively in the department.

Other employees in the department feed the raw material, and remove the finished parts and by-products. Because of the long set-up times, production of standard parts is scheduled in large batches. For example, one part which takes 13 seconds of machining time is produced in a lot size of 20,000 pieces. The large batch would then go into inventory and released for further processing in smaller lot sizes, depending on final demand. Some components are produced continuously, others run for between 2 to 10 shifts.

Tool preparation is another major activity in this department. A set-up schedule provides information on the need for tools and machine parts. The same people do the set-ups and prepare the tools. Tool preparation takes an average of 2.5 hours, but can, of course, be done while the machine is running. An average of seven of the 35 machines would be in the set-up stage each day. Nearly $6 million of inventory of fixtures and tools support the turning machines. After a part leaves a turning machine, it is hardened in a furnace, heat treated, and inspected.

Steel parts and other components are brought together in the electrical motor production line. This department contains a fully automated line that winds wire, attaches a fan and insulators, and balances the component that becomes the motor for the hand tool. This highly automated process is replicated on a smaller scale by hand for certain custom applications and for spare parts no longer in standard production.

In final assembly, purchased parts and manufactured components are manually assembled into finished products. The finished product parts list contains 80 to 100 items, all of which must be available at the right time. The finished product receives a final electrical test and is then packaged and shipped through a fully automated distribution centre.

The throughput time from casting aluminium to the finished product is 6 to 8 weeks. Grinding wheels, customised special machines, and in-house tool making and production machinery are produced in separate production areas.

The Old Cost System

Powerhugs provided a complex information management environment. The complexity was tough to track even with extensive use of computers by the old cost system. The system's main task was to compute actual total costs. It contained the three classic cost accounting elements: accumulate costs by accounts, by cost centres, and by products. Sub-systems, such as materials control and wage control, provided inputs into the product costing module. Costs were distributed from 200 different cost accounts to 250 cost centres or work orders.

Product costs were built up from material master accounts, parts lists, and work plans. Secondary (support) centre costs were allocated to primary (production) cost centres, using causal relations as much as possible, such as through internal work orders. The overhead allocation was done manually twice a year (in September for budgeting purposes and to compute standard costs for the year, and at year end to eliminate errors and use actual rather than budgeted amounts). The task required 3-4 weeks for a highly qualified person.

Product cost components were:

Materials Direct labour

Materials overhead Re-employed parts Fringe benefits Production overhead Special costs

applied as a percentage of materials cost the term for sub-assemblies

applied based on direct labour cost

applied using machine hour rates based on capacity utilisation

Such as tooling

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An analytic study was conducted once per year to determine individual machine hour rates. Costs arising at the individual cost centres were assigned to each machine in the centre and divided by the machine's estimated annual volume. The rates were estimated at the beginning of each year using the actual experience from the prior year. Powerhugs had 1,500 such machine hour rates. Miller noted that many companies continued to allocate overhead to products based on direct labour. Powerhugs had been using machine hour rates since the early 1970s.

Six categories of traceable costs could be directly allocated to the machines:

Depreciation: straight line based on replacement value. (The calculation based on replacement costs was done for internal purposes only)

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3 Space

4 Energy: based on run time and machine horsepower

5 Maintenance: estimated based on experience and industry averages (including oil and grease)

6 Tooling

Costs that could not be traced directly to machines were aggregated at the cost centre and allocated to individual machines as a percentage mark-up of the traceable costs. The rates had ranged between 200 to 300% of traceable costs, but this procedure caused problems by heavily burdening expensive, automated machines. In order to avoid over-burdening such newly purchased machines with large components of non-traceable costs, a compromise solution was adopted to allocate 50% of the non-traceable costs based on machine hours and 50% based on traceable costs.

Problems with the Old System

Despite the sophistication and care taken when designing Powerhugs' old cost system, it no longer satisfied top management's requirements. First, the manual processing of the data at the beginning and end of year was inefficient and costly. Second, long time lags occurred between data collection and feedback so that operators could not get timely information about what was happening in their cost centres. Thus, operators were not very cost conscious. Also, since the machine rates were only calculated once a year and not split into variable and fixed components, major errors were introduced by fluctuations in capacity utilisation. After a very good year, machine burden rates would plummet and after a bad year the rates became much more expensive. While Mr. Miller, based on his personal experience, tried to make some adjustments to dampen extreme variations in rates, the results were not satisfactory.

No budgets were prepared so that actual results could not be compared against a standard. Even with a budget, the information would have been meaningless to cost centre managers because of the inability to control for the actual level of activity in a period. The degree of aggregation at a cost centre produced additional problems. For example, the aluminium foundry and injection moulding department were treated as a single cost centre even though several different machines with different degrees of automation and labour intensity were used in each facility. In the steel

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Imputed interest: based on 50% of machine's replacement value. (A long-term (3 to 5 year) bank lending rate was used to charge interest expense on inventory and fixed assets. Currently this rate was in the 5- 6% range)

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treatment area, all 6-spindle machines were in the same cost centre, and in the motor production area, the fully automated and the hand assembly operations were included in the same cost centre.

Also producing errors was the practice of charging fringe benefits (a very high cost component in Naringin) to the cost centre where a worker was originally assigned, while the actual direct labour charge was made to the cost centre where he or she performed the work. Naringin workers could perform a variety of skilled tasks and were rotated frequently among cost centres.

Since batch sizes varied from process to process, the job order accounting approach presented another serious problem. In the aluminium foundry, a job order could be written up for 4,000 pieces of a component. If the process were running smoothly, the supervisor could decide to produce enough to release 4,500 good pieces to the next stage. Omitted from this count would be items produced in the batch but which had been set aside as scrap or rework. On the other hand, a few hundred pieces could have been added to the batch after they had been reworked from a previous batch

With the old system, all the costs of working on the order would be accumulated and then divided by the number of good parts that left the production stage when computing a cost per unit. To get any useful information from such data, one person had to spend a month on a special study to track down the production costs associated with a single end-product.

Miller explained:

You can't expect a production supervisor or technician to explain a total product cost variance. He needs information that relates directly to the process he is controlling. Only if you show him things like excess tooling expense, indirect materials and the actual quantity produced at that stage can he start to respond on the source of the deviation.

A final flaw in the system was the difficulty of integrating cost accounting with financial accounting. The product cost figures used internally were different from those needed for financial reporting because of differing methods of depreciation (straight-line versus accelerated, and replacement value versus historical cost) and the use of imputed interest for internal measurement of product costs that was not allowed for external reporting. The reconciliation between the two systems was tedious and painful.

In Search of the Perfect System

Mr. Miller still gets a tortured look on his face when thinking of the old system. He was pleased when top management had decided that a new cost system was needed. His background included extensive shop floor experience starting, after school, as an apprenticeship at a machine tool company. While a machining apprentice, he had to fill in for the purchasing manager who became sick. In this position he learned how little office and staff people knew of actual operations. He decided to do a second more technical apprenticeship which occurred at Powerhugs. After one and a half years in the technical service division of a construction machinery producer he pursued studies in business. In 1972 he joined Powerhugs' control department. Miller, because of his technical background and his excellent relationship with the people on the shop floor, was put in charge of developing the new control system. Miller concurred:

It is easier to familiarize an engineer or technician with some basic economic principles than the other way around. An engineer has a feeling for the production process, can relate to it. Many corporate controllers can't do that. While the old system was certainly better than no system at all, top management decided that they needed something better. They began their search and came across the Systlabs system and SAP software.

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The Systlabs and SAP Systems

Systlabs - a Naringin-based consulting firm was a leader in developing and installing sophisticated cost systems for major industrial clients in West Naringin, and throughout Europe. SAP was founded in 1972 by four former IBM computer scientists to design efficient software for data processing in business and manufacturing applications. One SAP founder, Dr. Plattner, had met Systlabs in 1984 and the two companies decided to combine Systlabs' sophisticated cost control systems with SAP's leading-edge main frame software. Systlabs would do the consulting work for the client's specific problems and SAP would install and integrate its system with the client's operations. Mr. Miller found that the SAP/Systlabs system could satisfy the criteria top management had specified for a good system.

Implementation

The new cost management system used flexible, standard costing for cost budgeting, accounting, and control. Three functions were included:

1. Cost centre accounting for manufacturing overhead cost control

2. Production costing for product cost control

3. Planning/simulation for strategic costing on a "what-if" basis

Overhead cost control was the initial area of implementation. New cost centres had to be defined and appropriate activity bases selected for manufacturing, service, and support centres. Only similar machines with an identical relationship between incurred costs and the chosen activity base were grouped into the same cost centre. Thus, highly automated machines, such as in a CIM centre, were placed in a separate cost centre from operator-controlled machines. The number of cost centres had to increase from 250 to 600.

Activity bases for each cost centre were chosen from operating parameter such as machine hours, labour hours, set- up hours, kg of material, number of pieces, kilowatt hours, and square metres of material. Occasionally, multiple activity bases, such as machining hours and set-up hours, were used in the same cost centre to distribute costs.

Once new cost centres and activity bases were defined, flexible budgets were prepared for each cost centre. Budgeted costs were estimated, using analytic not historical cost methods, for each manufacturing, service, and support cost centre. Each cost centre had about 70 different input resources identified, leading to more than 40,000 entries.

Primary costs, such as direct and indirect labour, indirect materials, energy consumption, machine costs and outside services, were traced directly to each individual cost centre. Secondary costs were allocated from service and support cost centres based on the quantities of secondary department resources used by the manufacturing (primary) cost centres. The budgeted secondary cost rates were determined by planned, not actual, volumes of consumption of secondary support resources. The budgeted cost rates were applied ex post based on the actual volume of demands made by production cost centres, as a function of their operating activities, on the support and service cost centres. For the secondary cost centres where the output could not be easily measured by quantities, percentage allocations were used.

Each primary and secondary budgeted cost was split into variable (proportional) and fixed components, based on the relation between the cost element and the chosen activity base for the cost centre. The final fixed and variable cost rates were used both for product costing and to authorise overhead costs at the cost centre level

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Overhead cost control was accomplished with the cost centre budget performance report. Actual costs incurred at the cost centre, including both primary and secondary costs, were compared with the authorised cost for the cost centre, based on the actual activity base volume at the cost centre. A variety of variances - usage, price, rate and volume were computed and displayed.

Standard product costs could now be computed. The bill of materials and routing sheets supplied information on standard material quantities and processing times. The cost standards for material prices and manufacturing cost rates at each cost centre could then be applied to obtain standard product costs for all product codes - parts, sub-assembly groups, and finished products based on standard performance and standard rates. These frozen standards were used for profit planning and for inventory valuation. Updated for changes in the bills of materials, input prices, or changes in processing routes and times, they could be used for current manufacturing cost control. That is costs would be authorised based on production work orders.

Product cost control was evaluated with the production work order performance report. Actual costs incurred - including direct materials use and manufacturing resource consumption - were compared with the authorised cost which equalled the current standard product cost per unit multiplied by the actual quantity produced. Price (materials, cost rate) and performance (materials usage, manufacturing efficiency, and alternative routing) variances were separately identified. Absorption of product cost into inventory was accomplished using current standard product cost rates so that all production cost variances were expensed as period costs. In addition, management accounting cost procedures such as straight-line depreciation based on replacement costs which were not allowable for financial (external) accounting purposes were offset in a reconciliation routine when preparing the semi-annual financial reports.

The new cost system maintained highly detailed records to measure accurately the actual activity volume at each manufacturing operation and at each of the 600 cost centres. Performance reports were produced monthly to summarise actual versus authorised performance, but the information behind these reports were continuously available, on-line, for immediate feedback. The detailed and accurate record keeping enabled manufacturing variances to be easily explained. For example, an unfavourable cost centre variance could be traced either to events at the centre itself or back to a secondary service/support centre that had been reallocated to it.

Planning and simulation analysis could be easily performed because all costs, at both primary and secondary centres, could be flexed with respect to fluctuations in product volume and mix assumptions. What-if simulations could be based on changes in activity base or production quantity volumes, and with respect to changes in labour rates, material prices, energy costs, tariffs, etc. Structural changes affecting the split of costs into fixed and variable components, or on resource and activity base consumption, would be entered manually before performing the simulation study.

Payoffs to Powerhugs

Miller felt that Powerhugs' new cost system provided several major benefits to the company. The visibility and traceability of costs down to the lowest level in the organisation enabled problems to be uncovered that had been hidden or averaged across units by the prior system. The information on marginal costs made it possible to compute accurate flexible budgets. The more accurate and detailed system gave all employees much greater confidence in the validity and reliability of the cost data. Costs could now be predicted as a function of production volume thereby eliminating a major source of uncertainty in the previous system. Problems could be traced to their source and remedied immediately. Operators had to accept responsibility for costs charged to their cost centres whereas previously they had argued that excessive costs were introduced at previous stages, or were the consequence of over- charges from the secondary cost centres, or arose from errors introduced by the average, total cost system.

The ability to reconcile data between the financial accounting and the cost accounting systems was another major advantage. The two systems were now compatible which made tax planning and audits much easier Auditors who questioned the minutest detail could access and investigate the underlying transactions record. Thus, Powerhugs now

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enjoyed the advantages of an effective cost control system, driven by the underlying production process, while still able to produce product cost information acceptable for the financial accounting statements.

The flexibility and power of the SAP software system made complex simulations and scenario planning possible. But the system had yet to be used to make product-related decisions. Pricing product introduction, and product elimination decisions had been unaffected by the information from the new system.

Miller emphasised:

Pricing is determined in the marketplace. We cannot use product cost information to determine our pricing. Also, we must offer a full product line. Previously, our brand position was so strong that customers would purchase only Powerhugs products. Now, however, if we do not offer a product model, the consumer may purchase a competitor's product. Compromising our full product line is not a good option.

Miller summarised his feeling about the new system:

Knowing, finally, what is going on and not tapping in the dark with a pile of information that could be more damaging then beneficial has given me an incredibly good feeling

Question 1: The following question relate to Powerhugs old cost system:

a) Discuss Powerhugs old cost system.

b) Describe five (5) problems that existed with the old costing method?

c) discuss two (2) benefits to the old costing system?

Question 2: The following question relate to Powerhugs new cost system:

a) Explain what changes were introduced with the new cost system?

b) Describe how the new costing system is beneficial. Describe how the new costing system would possible be improved further.