Pioneer Electronics Inc (PEI) operates in the computer industry. PEI has two divisions: the Lap Top Computer Division and the Maintenance & Repaid (MR) Division. The computer division manufactures computers in several plants located in Eastern Canada. The product lines run from relatively simple economic models to high end multi function designs. PEI also operates an MR division in Montreal. The MR division offers three products: Standard, Plus and Star. The MR Division reported the following activity for the month of February: Standard Plus Star Sales (units) Price per unit Unit costs: Directly traced Overhead - Driver traced Overhead - Allocated 50,000 16 $ 500,000 30 $ 300,000 $ 40 5 $ 3 $ 2 $ 10 $ $ 7 $ 4 $ 6. $ 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 and is also the only variable cost. All other costs are fixed. 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. David Collins, the president of PEI, is reasonably satisfied with the performance of the MR Division. February's performance is fairly typical of what has been happening over the past two years. The Computer 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. February's 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 February, the Computer Division reported the following results: Inventories: Materials, February 1 Materials, February 28 Work in process, February 1 Work in process, February 28 Finished goods February 1 Finished goods, February 28 Costs: $ 23,000 $ 40,000 130,000 $ $ 45,000 $ 480,000 375,000 $ Direct Labour $ 117,000 Plant and equipment depreciation Materials handling Inspections Scheduling $ 50,000 $ 85,000 2$ 60,000 $ 30,000 30,000 Power $ Plant supervision Manufacturing enginerring $ 12,000 $ 21,000 120,000 Sales commission $ $ Salary, sales supervisor Supplies Warranty work Rework 10,000 $ 17,000 $ 40,000 $ 30,000 The warranty work is under the responsibility of the sales group. The rework is usually related to production defects that need to be fixed before shipping the product to the customer. During February, the computer division purchased materials totaling $312,000. There are no significant inventories of supplies (beginning or ending). Supplies are accounted for separately from materials. PEI's computer division had sales totaling $1,170,000 for February. Based on February's results, David decided to meet with three of the computer division's managers: Kate Williams, divisional manager; John Smith, divisional controller; and Tony Lee, sales manager. A transcript of their recorded conversation is given next: David: "February'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. Kate, what's your assessment of the situation?" Kate: "Foreign competition is eating us alive. They are coming in with lower-priced Computers 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." Tony: "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." John: "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." Tony: "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 over-costed, then we could offer immediate price reductions." David: "John, I need more explanation. We have been using the same cost accounting system for the last 10 years. Why would it be a problem?" John: "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." David: "This may be something we should explore. John, what do you suggest?" John: "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 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." David: "What do you think, Kate? It's your division." Kate: "What John 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. John, 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?" John: "I have already been gathering data. I could probably have a report within two weeks TO: Kate Williams FROM: John Smith SUBJECT: Preliminary Analysis Based on my initial analysis, I am confident that an ABC system will offer significant improvement. For one of our conventional Computer plants, I regressed total monthly overhead cost on monthly direct labor cost using the following 15 months of data: Direct Labor Overhead 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 95,000 115,000 100,000 410,000 375,000 360,000 85,000 340,000 85,000 90,000 80,000 330,000 300,000 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 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 doesn't provide the number of moves, so I had to build the data set by interviewing production personnel.) This information is provided next: Materials- Number of Handling Cost 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 73,000 83,000 1,350 1,400 84,000 1,600 The regression results were impressive. (See results in Appendix 1). 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. After receiving the memo, Kate was intrigued. She then asked John to use the same computer plant as a pilot for a preliminary ABC analysis. She instructed him to assign all overhead costs to the plant's 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 significant cost; from production reports, she also knew that the rework activity involved significant 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, John produced the following cost and driver information: Activity acity $ 1,250,000 Activity Expected Cost Driver Other activities $ 2,000,000 Direct labour dollars Moving materials Inspecting Reworking Total overhead costs 900,000 Number of moves 18,000 $ 720,000 Inspection hours 380,000 Rework hours 24,000 $ 3,800 $ 4,000,000 Expected activity demands: Units completed Direct labor dollars Number of moves Inspection hours Rework hours Regular Model Deluxe Model 100,000 $875,000 7,200 6,000 1,900 40,000 $375,000 10,800 18,000 1,900 Required: 1. Compute two different unit costs for each of the MR Division's products based on these 2 management objectives : Financial reporting and Pricing. (6 Marks) 2. Discuss the differences between the MR Division's products and the Computer Division's products. (6 Marks) 3. Prepare an income statement for the MR Division for February using the format for financial reporting purposes. (9 Marks) 4. For the MR Division, calculate the breakeven point by the bundle for the whole division and also for each product line. Determine and comment on the margin of safety % for the division. (10 Marks) 5. Prepare an income statement for the Computer Division for February. Include a supporting cost of goods manufactured statement. Calculate the prime and conversion costs for the month of February. David is under the impression that total manufacturing costs will equal to the total of prime and conversion costs. Advise David if he is correct in his understanding. (27 Marks) 6. The Computer Division has been using the same cost accounting system for over 10 years. Explain why its cost accounting system may be outmoded. What factors determine when a new cost accounting system is warranted? (5 Marks) 7. Based on the regression results shown in Appendix 1, comment on John Smith's observations concerning the outcomes. (6 Marks) 8. Determine a separate cost function formula using (a) the regression analysis from Appendix 1 and (b) the high low method regarding the materials handling costs. Discuss which of these method better formula to be used for cost estimates and why. (11 marks) 9. Calculate the overhead cost per unit for each computer model using direct labor cost to assign all overhead costs to products. (6 Marks) 10. Calculate the overhead cost per unit using the four activities and drivers identified by Kate and John. If you were Kate, would you be inclined to implement an ABC system based on the evidence from this pilot test? (15 Marks) 11. Do you think the above information is adequate to improve the performance of PEI and explain? Discuss three other initiatives which PEI should consider to turn their business around and explain why do you think these initiatives will help the current situation with PEI? (9 Marks)