MANEGERIAL ACCOUNTING CASE STUDY.

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. TheCortland 1000 is a very popular computer with a large production and sales volume. By contrast, theCortland 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!

EXHIBIT 1

Direct Manufacturing Costs for ONE Computer Cortland 1000

Cortland 2000

Direct Material

$1,000

$2,500

Direct Labor

$200

$400

EXHIBIT 2 Analysis of 2010 Budgeted Manufacturing Overhead Costs

Activity

Cost driver

Budgeted activity (for entire company)

Budgeted cost

Receive/handle raw material

Orders received

200 orders

$90,000,000

Adjust/set up machines

Number of setups

2,000 setups

$12,000,000

Inspect, pack, ship computers

Batches

500 batches

$60,000,000

Inspect raw materials

Inspection hours

200,000 insp. hr.

$10,000,000

Solder parts

Soldering hours

200,000 sdr. hr.

$12,000,000

Assemble computers

Assembly hours

100,000 assm. hr.

$12,000,000

Total overhead

$196,000,000

EXHIBIT 3

Production Data for Cortland 1000 and Cortland 2,000 Computers Item

Item

Measure

Cortland 1000

Cortland 2000

Budgeted production

Number of computers

20,000

5,000

Received order size*

Size of order

10,000

500

Batch size

Number of computers

5,000

100

Machine setups

Number of s/u per batch

5

6

Inspecting time (Raw mat.)

Hours / computer

1

2

Soldering time

Hours / computer

3

1

Assembly time

Hours / computer

1

1

**Received order size is the number of computers one order of raw materials will build. Thus, for example, (see above) the company receives 2 orders of raw materials for the Cortland 1,000. Calculation: 20,000computers per year, divided by 10,000 computers each order will build = 2 orders per year.

*Questions*

1. 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?

2. What are the reasons for the differences between the two systems? More generally, what are the characteristics of a computer whose manufacturing cost will increase under the product costing system being proposed by the accountant? Please be specific.

3. What should Mr. Works do?

PS: I need to write a 10 page paper on these three questions, so please be very detailed, Thank you.