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BACKGROUND High-Tech (H-T) is a computer manufacturer founded in New York in 1901. H-T originated as a commercial scale, cheese and meat slicing, punch card, tabulating and time recording conglomerate. The company began with 1,300 employees and with sales in Canada, D.C., Michigan, New York and Ohio. The company had a difficult time managing its diversified products in numerous locations. H-T undertook several strategies to overcome its faltering operations. First, H-T increased sales by implementing healthy sales incentives, grooming its salesmen in dark suits, promoting company pride and loyalty in its employees and beefing up customer services. Second, H-T focused on selling tabulating machines, and expanded sales to Asia, Australia, Europe and South America. These strategies helped H-T overcome its sinking operations. While other companies were folding during the depression, H-T continued to grow and began providing employee benefits such as life insurance and paid vacations. Just-in-time inventory control would not have been useful to H-T during the depression. Because H-T had large inventories on hand, they were able to undertake large government contracts during the 1930's. H-T had become so large in the computer industry that they were 6 constantly being sued, but unsuccessfully, for antitrust violations. During World War II, H-T continued to grow through government contracts. H-T used some of its profits to finance orphans and widows of war casualties. This goodwill act helped to foster employee loyalty and demonstrated good community citizenship. Technological development escalated beginning in the 1950s. H-T first developed a five ton 50-foot by eight-foot calculator. This calculator was replaced with vacuum tubes and later replaced with a mainframe transistor that was faster and smaller than the vacuum tube. By 1957, H-T had a spinning disk storage system that could assess and process accounting data on as many as 50 disks and introduced the FORTRAN computer language. H-T was so large that they supplied 90% of Europes computers, had $80 billion in sales and 270,000 employees. From 1970-80, H-T became the leading manufacturer of mainframe computers, hardware, software, and services. By the 1980s, H-T was manufacturing floppy disks, bank automatic teller machines and PCs for small businesses, schools and home use. H-T now has manufacturing plants located in Raleigh, NC and Essonnes, France. In Raleigh, NC, H-T manufactures low-end servers and personal computer systems and in Essonnes they manufacture logic and memory chips. H-T is now vertically integrated and produces, services, and sells products exclusively in the computer industry. More recently, H-T has experienced a downturn in earnings resulting from a very competitive computer industry. Systems Information. H-Ts corporate strategy is to get multi-year cooperative agreements with SAP adopters to increase H-Ts share of the computer hardware market. H-T uses a normal costing system where manufacturing overhead is applied and estimated annually and quarterly and all other costs are recorded at actual using a stand-alone weighted-average accounting 7 information and inventory system. Stand-alone implies that the cost accounting system is not integrated with financial accounting, finance or logistics ledgers. They hope to install SAP, an electronic resource planning system, but that has not happened yet. Because cost accounting is stand alone, at the end of each quarter considerable accounting effort is spent integrating cost data with financial accounting and logistics data. Each production location (Raleigh and Essonnes) is managed separately and within each location there is decentralization of functions. The cost accountants focus solely on budgeting, recording and analyzing costs. H-Ts organization chart and its financial statements-- income statement and balance sheet--appear below. 8 HT Organization Chart HT Organization Chart VP Human Resosurces VP Business Transformation Senior VP Strategy VP Govt. Prog. & Asst. Gen Counsel Senior VP Research VP Coporate Development and Real Estate Chairman of Finance and Credit Corp. VP and Controller Treasurer CFO Senior VP Personal Systems and Technology Group Chief Executive Officer Board of Directors High-Tech Corporation Income Statement At December 31 (Dollars in millions except per share amounts) 2002 2001 Revenues: Hardware Sales 36,500 35,700 Services revenues 15,000 12,000 Software sales 13,000 13,000 Maintenance revenues 7,000 7,000 Rentals and financing income 1,600 1,500 Total Revenues 73,100 69,200 Cost of sales: Hardware Sales 24,000 22,000 Services expenses 12,000 10,000 Software expenses 4,000 4,400 9 Maintenance expenses 3,600 3,600 Rentals and financing expenses 1,600 1,500 Total Cost of Sales 45,200 41,500 Gross Profit 27,900 27,700 Selling expense 15,000 15,200 Research & Development expense 4,000 4,000 Operating Income 8,900 8,500 Other income 9,000 8,000 Other expenses 710 720 Earnings before income taxes 17,190 15,780 Income tax expense 3,100 3,600 Net income 14,090 12,180 Dividends paid 22 60 Net income to common stockholders 14,068 12,120 10 High-Tech Corporation Balance Sheet At December 31 (Dollars in millions except per share amounts) 2002 2001 2002 2001 Assets Liabilities Current Assets: Current Liabilities: Cash and cash equivalents 7,680 7,260 Taxes payable 3,000 2,600 Marketable securities 500 450 Short term payables 13,000 11,500 Notes and accounts receivable 16,500 16,400 Accounts payable 5,000 4,500 Sales lease receivables 5,700 6,000 Compensation and benefits 3,000 3,000 Other receivables 900 1,000 Deferred income 3,700 3,500 Inventories 6,000 6,000 Other liabilities 6,600 6,500 Prepaid expenses 3,500 3,200 Total current liabilities 34,300 31,600 Total Current Assets 40,780 40,310 Long term liabilities 10,000 10,000 Property, plant and equipment 41,200 44,000 Other debt 14,000 14,300 Less: Accumulated Depreciation -25,000 -27,000 Deferred income taxes payable 1,600 1,800 Net property, plant and equipment 16,200 17,000 Total liabilities 59,900 57,700 Software - net 2,000 2,500 Stockholder's equity Investments & miscellaneous acct 22,500 20,600 Preferred Stock 353 353 Common Stock 8,500 8,400 Total Assets 81,480 80,410 Retained Earnings 10,327 10,657 Translation adjustment 2,400 3,300 Total stockholder's equity 21580 22710 Total liabilities and stockholder's equity 81,480 80,410 RALEIGH, NC The product development cycle for low-end servers and personal computer systems is three months. This means that faster and cheaper computers are developed at least three to four times a year. The computer industry experiences a 2-3% decline in raw material costs and selling prices each quarter. Therefore, product costs are changing constantly. While head count is high at Raleigh, this cost is stable and represents only about 5% of product cost. 70% of product cost is materials and 25% is manufacturing overhead. Traditionally, for manufacturing overhead in production, direct labor dollars have been the allocation base. Examples of servers produced by H-T appear on the following page. 11 12 Raleigh tries to trace most of its costs directly to the product. Labor and materials are traced directly to the product through bar codes. Each material input component is bar-coded and traced directly to the unit to which it is attached. As materials move through assembly, assemblers indicate which unit of output they are assembling through bar codes. For each product produced, a diskette includes the serial number assigned to the finished server, the assembler I.D. number and the identification number of parts used to make the server. Since the market fixes the price of labor and materials, H-T hopes to increase profit margins by reducing manufacturing overhead costs. H-T believes that it can reduce costs by reducing throughput time. Throughput is defined as follows: H-Ts strongest competitors reduce throughput time by eliminating the dealer. Their competitors sell directly to the final or end customer. However, the dealers provide a level of immediate service to end customers at the end customers location that is not provided by its competitors. Competitors customers have to call an 800 number and sometimes wait 30 minutes on the phone before a technician can answer their question. Many customers who have software installation problems must see a computer specialist at their own cost, or for other problems they may have to return their equipment to the vendor and wait 2-3 weeks before the computer is replaced or repaired. Therefore, H-T must weigh the benefits of selling through dealers to its end customers as opposed to reducing throughput time by eliminating dealers. Lead-time from dealer order to receipt of goods by the dealer is usually three to four weeks. Dealers generally hold five-week inventory levels to avoid stock-out costs and to compensate for 13 goods that may be damaged during shipment. If not sold immediately, dealers have unsold obsolete inventory on hand. In the past H-T has provided rebates to dealers for obsolete inventory. This way, dealers can offer obsolete inventory at discounted prices to their customers. H-T is concerned that this policy sends the wrong message to dealers. That is, if dealers dont move their inventory fast, the dealer doesnt lose because H-T will discount the merchandise. Therefore, dealers are not motivated to buy from H-T in small quantities or to sell their inventories quickly. H-T wants dealers to more accurately estimate their sales so that they dont end up with large quantities of obsolete inventory on hand. H-Ts competitors not only reduce dealer costs by not having dealers, but also reduce costs related to storing outdated inventory at the dealers location. H-T records procurement parts costs when invoiced. So if they invoice a purchase in March, they use February costs because March costs are not known at the time of invoicing. At the end of March, when H-T knows the actual cost of March purchases, they record the under- or over-applied materials/parts cost as the difference between actual and recorded parts cost. Variances are investigated at the top end of the organization, outside of the cost accounting department. Some variance is tolerated/expected due to the rapidly decreasing parts cost in the computer industry. Similarly, when dealers are billed for computers purchased, they are billed at the previous months price and the invoice price is adjusted the following month to reflect the actual selling price. That is, H-T does not know the cost of producing the computers and therefore the selling price of the computers until a month later when their vendors invoice raw materials. This is when H-T knows the actual cost of parts procurement. Sizing or the comparison of ledger to physical inventory is done annually. On the manufacturing floor, the flow of production of low-end servers is as follows: 14 Upon arrival, parts are debugged for defects. Non-defective items go in the storage bins until a unit of output is demanded. Once demanded, components needed to complete the order are placed in a basket. The basket (kit) contains the parts, and a diskette that has the part numbers, order number and debuggers identification number (I.D.) recorded on it. Upon leaving the kitting area, the order is debugged for errors in parts selected to complete the order. The debuggers I.D. is entered on the diskette. The assembler, one person, then assembles the server. The assembler must enter their I.D. on the diskette and verify the parts received. After assembling, the assembler checks the machine for mechanical failure. Once completed, the machine, its invoice order number and diskette go to the assembly inspection station. The inspector enters their I.D. on the diskette and inspects the completed server. The inspector inserts software into the machines to conduct the appropriate tests. If a defect is detected, the inspector flags the assembler and stops that assemblers operations until the problem is fixed. Goods cannot move to the next station (i.e., from parts selection, to kitting to assembly to shipping) until the previous station has quality output. Servers are the high profit margin products for H-T so they stress quality (< 2% defect rate) in production. The inspector indicates on the diskette which quality-tests have been conducted and removes all testing software not requested by the customer. Finally, the server is boxed and sent to shipping. A history of the production and inspection of the machine is kept on diskette and mailed to the central office. Information from this diskette is used to trace materials and labor costs directly to output. In production, all overhead is allocated to products using number of parts as the cost driver. A server could require from twenty to thirty parts, depending on the customers specifications. All servers are packed in identical size boxes and manufacturing time depends on the number of parts tested. 15 Shipment of almost all of H-Ts products (servers, PCs and mainframes) is out of Raleigh. In addition to the production area, Raleigh has 450,000 square feet of warehousing space. Inventory is in the warehouse for an average of 10-15 days before shipping. H-T uses activity-based-costing (ABC) to allocate annual warehousing and shipping costs to each product as follows (in millions): Cost Driver Hours Hours Activities Indirect Square Foot Scanning Out- Information Head Count Floor Space Bound Freight Systems Receiving (from mfg.) $50 $ 15.5 Shipping parts to shipping lane $120 $ 12.0 Storage $ 700.5 $ 10.5 Transportation out $185 $30 $ 10.0 Annual allocation of expenses to products is then conducted as follows: Desk Top Server Monitor Lap Tops Options Receiving Head Count 1,000 500 600 1,200 400 Info. Systems (hrs) 600 120 100 800 60 Shipping parts to lane Head Count 800 100 100 800 20 Info. Systems (hrs) 80 10 60 80 15 Storage Floor Space 1,000 2,000 600 800 400 Info. Systems (hrs) 100 100 100 100 100 Trans-out Head Count 70 120 50 80 20 Info. Systems (hrs) 20 15 10 20 5 Scanning Hours 10 5 5 10 2 For some parts, transportation-out is the highest cost (servers). For example, servers have high transportation-out costs because they are heavy. For other products, order filling is the highest 16 cost (desktops). For example, desktops absorb high order filling costs because desktops are composed of multiple individual parts. The desktops may have 10-15 pieces to a box so it takes more time to fill a desktop order than a server order, which is composed of one or two parts. Examples of desktops produced appear on the following page. 17 ESSONNES, FRANCE In Essonnes, France, H-T manufactures logic and memory chips from a silicon wafer. The silicon wafers are sliced from a silicon cylinder. The silicon cylinders are $400 each. Each working day H-T manufactures approximately 1,200 wafers. (An example of a silicon wafer appears below.) In Essonnes, production takes places 24 hours a day, seven days a week and 52 weeks a year. The only days off are May 1 because the French law of 1936 requires it and December 25. However, accounting executives working hours are generally 8:30 a.m. to 6:00 p.m., five days a week. H-T purchases silicon cylinders for $400 each. Approximately 125 wafers can be sliced from each cylinder. During slicing, there is a loss of 20% of the silicon cylinder. They have quality assurance contracts with their vendors to assure the quality and on-time delivery of their production parts (silicon cylinders). After an order is received, H-T slices the silicon cylinders into wafers. 18 After slicing the cylinder into wafers, these wafers are cleaned and chemically coated during joint processing. Also, in joint processing, H-T incurs monthly property plant and equipment-depreciation expense, taxes, patent amortization, and other factory overhead costs of $120,000. H-Ts salaried engineers in the joint processing department earn a total annual payroll of $2,070,000 a year. The joint processing of the wafer results in two distinct products, memory chips and logic chips. Quality control is very important in processing the wafer, even the air is filtered and controlled and the equipment used to make the chips is monitored closely by engineers for quality of production. It takes 250 steps of processing and 150 quality control steps to produce a finished wafer. Rooms full of tools and expensive high tech equipment are used in the production area. Manufacturing includes using an ultraviolet light to project the memory chip images onto the wafer. During the testing phase, each wafer is tested and visually inspected. Materials cost beyond joint processing is negligible. However, manufacturing overhead is substantial and includes information systems, utilities, maintenance and quality assurance. End-of-line includes dicing the wafer and picking the good memory and logic chips from the wafer. Each chip is charged to H-Ts internal customers at cost plus ten percent. From each wafer H-T can usually get a total of 100 logic chips and 400 memory chips of which 5% of the good output is loss. The loss is detected at the end of production. To minimize costs, H-T is currently focusing on increasing the yield from each cylinder and wafer. Some waste is expected because square chips are being manufactured on a round wafer. Production cost and time flows are as follows: After end-of-line, the chips go to production control where they are distributed to their internal 19 customers at a transfer price of 10% above total production cost. H-T spends considerable effort in developing and implementing its budget. H-T prepares five-year strategic plans from which flow yearly budgets and quarterly budgets. The annual budgets begin with actual data that is negotiated with production managers to produce annual and quarterly budgets. Budgeting involves a cross-functional team to insure optimal corporate goal congruence (as opposed to unit-focused goals that may be suboptimal to the corporation as a whole). Upper management has weekly technical meetings with production regarding yield, lead-time, and quality of shipped output. Each quarter (3 months), H-T compares actual with monthly budgets. Usage of the service department centers during 2002 follows. 2002 JOINT PROCESSING COST CENTER H-Ts Actual Usage for the Year Information Quality Suppliers Systems Utilities Maintenance Assurance (Computer (Square (labor hours (# people on hours) kilometers) used) production line) Users of joint processing service departments Utilities 500 70,000 100 Maintenance 1,200 1,000 60,000 100 Memory Chip 500 2,000 12,000 500 Logic Chip 500 1,000 60,000 800 The budgeted charge-out rate for information systems is $10,000/hour, for utilities is $20,000/square kilometer, for maintenance is $80/labor hour and for quality assurance is $52,000/person. Information systems include the salaries of personnel, accounting and budgeting costs and costs associated with the mainframe central processing unit. Utilities include building repairs, 20 electricity, water, fuel, property taxes, and building depreciation. Maintenance involves servicing the machinery used in production and computers and mainframe systems used throughout H-T. Quality assurance represents those personnel who measure quality and who conduct surveys on supplier, employee and customer satisfaction. Full absorption costing is used to determine product costs. For the French definition of full absorption costing, see Bescos and Mendoza (1995). H-T wants to assign costs so that managers maximize the quality of output and reduce the percentage of spoiled chips from each cylinder and wafer (yield). Currently H-T uses a traditional normal costing system and allocates all processing costs to the good chips only. H-T also wants a cost system that accurately allocates overhead costs to chips. To monitor quality, H-T continuously queries its suppliers, employees and customers. Employee satisfaction is important because they believe the more satisfied the employee, the more likely the employee will seek to achieve quality output efficiently. In France, the employees are very concerned about job stability as a result of the downsizing that has taken place. H-T has reduced the number of buildings occupied by 60%, the number of employees by 40% and has increased production 100% over the past five years as a result of increased technology in its production facilities. Thus, employees are working harder to achieve corporate goals in a competitive environment. Customer surveys include questions about on-time delivery. H-T strives to have a 98-99% on-time delivery rate. 21 IMPLEMENTING AND MONITORING STRATEGY Corporate and Raleigh, NC ARE STANDARD AND ACTIVITY BASED COSTING APPROPRIATE FOR H-T? Raleigh, NC H-T is contemplating using activity based costing (ABC). Answer the following questions about the Raleigh, North Carolina location. 1. Would you recommend that H-T consider using activity-based-costing throughout the Raleigh plant site? That is, H-T is currently using ABC in the warehousing area only