Costs Concepts and Cost Behavior

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Objective:

Learn how cost behavior can be used to identify opportunities to improve profitability.

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Introduction:

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 two plants located in the Midwest: (1) a conventional phone plant and (2) cellular phone plant. 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 sale and unit cost activity for the month of March:

CableTech Bell Corporation Cable Service Division For the Month Ended March, 20XX
	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 cost driver used for tracing. Typically, the Cable Service Division uses only production costs to define unit costs. The preceding unit product cost information was provided at the request of the marketing manager, Dan Moniker, and was the result of a special study.

Bryce Youngers, the President of CTB, is reasonably satisfied with the March performance of the Cable Service Division. The March numbers were fairly typical of what has been happening over the past two years. The Phone Division, however, is another matter as its overall profit performance has been declining. Two years ago the Phone Division's income before income taxes was about 15 percent of sales. March's dismal performance was typical of the entire calendar year. This performance trend is expected to continue unless management takes actions to reverse it. During March, the Phone Division reported the following results:

CableTech Bell Corporation Phone Division For the Month of March, 20XX
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
Material 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. CTB's Phone Division had sales totaling $1,170,000 for the month of March.

Based on March's results, Byrce decided to meet with Kim Breashears, manager of the Phone Division and Jacob Carder, divisional controller. A partial transcript of their conversation is provided below:

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-selling phones at a lower price and high quality. 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. We are spending a lot of money each month on inspection, rework and warranties. I'd like to see these costs cost cut by 70 to 80 percent. If we could do that by improving quality, then customers would be more satisfied with our products, and we would not only regain our market share but increase it."

Jacob: "Kim, you mention reducing the costs of inspection, reworking, and warranties. For the inspection activity, 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 inspectors actually work only about 80 percent of those hours. Rework cost is simply the cost of replacing some faulty components and the associated direct labor. The rework cost per unit is predictable and constant per unit regardless of the product model. Warranty cost, on the other hand, involves the salaries of two technicians, with the remaining cost the cost of replacement components, which is relatively constant per unit repaired. The technicians are paid $5,000 per month and provide 2,000 hours of service per year. Warranty service usually requires 3,600 technician hours per year."

Bryce: "Interesting. I wonder what the effect would have been on March's income if quality had improved to the point where demand for these activities was cut in half."

Required:

1.

Inspection is a - Select your answer -variablefixedmixedstep-fixedItem 1 cost, with each - Select your answer -unitstepItem 2 being defined by inspection hours per year. Each - Select your answer -unitstepItem 4 costs $ . Current activity capacity is hours. Current demand for the inspection activity is hours.

2.

Rework is a - Select your answer -variablefixedmixedstep-fixedItem 8 cost.

3.

Warranty is a - Select your answer -variablefixedmixedstep-fixedItem 9 cost.

4.

Assume that quality improves so that the demand for the output of the inspection, rework, and warranty activities drops by 50 percent (with the company capturing all savings possible by reducing the resources currently used by the activities).

a.

Calculate the increase in March's pre-tax operating income produced by the savings for the following three activities:

Savings:
From inspection	$
From rework
From warranty
Total	$

b.

What is the percentage of sales represented by the new operating income (round percentage to nearest tenth)?

Operating income/Sales = %

Summary Questions:

1.	Inspection hours is a - Select your answer -unit-levelnon-unit levelItem 15 driver.
2.	If demand for inspection drops by 50 percent, the new demand is inspection hours and unused capacity is hours. Thus, steps can be saved which produces annual savings of $ .
3.	Savings from inspection reduces - Select your answer -cost of goods sold expenseselling expenseItem 20 .
4.	Savings from rework reduces - Select your answer -cost of goods sold expenseselling expenseItem 21 .
5.	Savings from warranty reduces - Select your answer -cost of goods sold expenseselling expenseItem 22 .