Neptune Networks, headquartered in Alexandria, VA, is a US-based aircraft component manufacturer. It was founded in 1957 by Dr. Scott Pope, an engineering professor at the George Washington University. Over the years, it has become a well-established networking supplier in many areas of homeland security. It consists of three departments: Civilian Networking Components (CNC), Military Networking Components (MNC) and Engineering & Tooling (ET).

CNC produces and supplies networking components for business networking and business security needs. CNC customers are typically located in big cities, close to Neptune's ET offices. CNC operates in a fairly competitive market; almost all of its products are considered "standard" in the industry. Thus, it prices its products using the market prevailing rates. Business typically update networks on a predicable schedule. Business typically place orders for parts several months in advance which gives Neptune plenty of time to schedule production and oftentimes enables Neptune to combine orders from different airlines into a single production run.

MNC is a defense contractor and produces certified networking components exclusively for the US Customs and Boarder Control, Federal Emergency Management Agency, Transportation Security Administration, and US Coast Guard (DHS). MNC locations are scattered around the United States to better serve the various DHS locations. MNC's products are uniquely researched and developed in house and protected by patents. MNC charges DHS a price equal to full cost plus a negotiated margin. In order to become more nimble, DHS moved to a JIT system which requires Neptune to produce parts on short notice and in small batches. While emergencies are infrequent and unexpected, DHS requires a quick response from Neptune in the event of one. Consequently, ET must store large quantities of raw materials to ensure it is ready if an emergency arises. Furthermore, emergency response network equipment usually operate in harsh conditions. As such, Neptune must test parts extensively under simulated conditions to ensure quality.

Finally, ET provides manufacturing support to both CNC and MNC that includes machine setup, inventory management, quality control, and customer service.

Neptune is currently mired in a public relations quagmire. In December 2022, DMV Post, a widely read and respected local newspaper, ran a scathing article accusing Neptune of excessively charging DHS a hefty sum for parts and making a big profit at tax payers' expense. Neptune has been working hard to restore its image and anticipated that the public would scrutinize its financials.

Existing Cost System at Neptune

The existing cost system at Neptune calculates costs for CNC and MNC. Costs at CNC and MNC include direct labor and direct materials. The direct labor and direct materials costs are variable costs varying with the volume of parts. Costs at ET are treated as overhead and allocated to CNC and MNC based on the total number of parts. Costs at ET include machine setup, inventory management, quality control, and customer service. The budgeted operating income statement for Neptune in 2023 is provided in Exhibit 1. The expected volume of parts for CNC and MNC is 800,000 and 400,000, respectively.

A New Cost Study - ****ABC

William Pope, a Senior Vice President of Neptune, is concerned with the high budgeted cost at CNC in 2023 and wonders whether more time and attention should focus on the DHS business. To more precisely assess each department's performance, in January 2023 Mr. Pope hired an outside consultant to conduct a new cost study which reveals the following information.

1. Machine setup costs are generally incurred as the production line is being prepared. These costs do not related to the size of the production run or the type of network. Rather, the costs seem to vary with the number of setups.

1. Inventory management costs refer to the costs incurred in storing raw materials. The costs seem to be caused by weight time. Weight time is an item's weight (by pounds) multiplied by the length of time the item stays in ET's warehouse. Both the length of time that inventory is stored and the weight of the item impact the inventory cost incurred by Neptune.

1. Quality control costs appear to be driven by the number of tests conducted. More sophisticated network components require more testing. This driver seems to proxy for testing sophistication.

1. Customer service costs are incurred when Neptune sends its service personnel to its customers for emergency repairs. These costs seem to be primarily related to the number of travel miles.

1. The direct labor and direct materials costs at CNC and MNC are evaluated the same as in the existing system; these are variable costs varying with the volume of parts.

Exhibit 2 contains some of the operating data the consultant projected for 2023. William Pope understood that the pricing of MNC parts would be affected by any change in Neptune's cost system during 2023 (while the negotiated margin would remain the same).

Recent Developments

ET's quality control service recently purchased a piece of testing equipment, called High Capacity Network Throughput Probe (HCNTP), that detects latency issues. It intends to offer this machine to be used by external customers only. The machine's useful life is 1 year and its capacity is 400 tests; its fixed cost (including acquisition cost) is $1,000,000; its variable cost is $5,000 per test. Three businesses have expressed interest in using this machine. Combined, these three customers plan to conduct 200 tests. Neptune expects to charge a 10% margin on its "reasonable" cost of serving these customers but is struggling with how to determine what constitutes a "reasonable" cost.

The actual number of parts sold in 2023 is 1,250,000 and 200,000 for CNC and MNC, respectively. Exhibit 3 provides data on budgeted and actual direct materials costs in 2023.

Neptune is also in the process of compiling its budget for 2024. 20% of machine setup costs and 40% of quality control costs are fixed, while all other ET costs are fixed. Exhibit 4 contains some of its projections for 2024.

Exhibit 1: Budget Operating Income Statement

Revenue: 3,600,000,000

Costs:

Direct Labor: 300,000,000

Direct Material: 600,000,000

Machine Setup: 270,000,000

Inventory Management: 500,000,000

Quality Control: 600,000,000

Customer Service: 200,000,000

Operating Profit: 1,130,000,000

Exhibit 2: Operating Data for 2023

Number of setups: CNC is 30,000 and MNC is 60,000

Direct inventory weight by pounds: CNC is 500,000 and MNC is 250,000

Days in Direct Material inventory: CNC is 10 and MNC is 40

Number of tests: CNC is 1,000,000 and MNC is 4,000,000

Travel miles: CNC is 500,000 and MNC is 4,500,000

Exhibit 3: Budgeted and Actual Direct Materials Usage in 2023

Civilian-focused business: Budgeted 200 price per pound and $400,000,000 of direct material used. The actual price was 150 per pound and $750,000,000 of direct material used.

Government-focused business: Budgeted 400 price per pound and $200,000,000 of direct material used. The actual price was 500 per pound and $180,000,000 of direct material used.

Exhibit 4: 2024 Budget Assumptions

Revenue: 4,000,000,000

Direct Labor Cost: 400,000,000

Direct Material Cost: 550,000,000

Number of Setups: 99,000

Number of Tests: 6,000,000

Travel Miles: 4,000,000

Question 1:Suppose there is no competitor that offers similar tests to those conducted by HCNTP. How should Neptune charge HCNTP's users for usage? Be specific in your answer using data provided by the case. Explain your answer.

Question 2:How will youranswer above change if competitors offer similar tests to those conducted by HCNTP? What is the minimum that Neptune can charge and be no worse off? (No calculation is needed for this question.)

Question 3: Based on your answer to question 2, how many tests does Neptune have to complete to ensure that it breaks even on the HCNTP (the new equipment)?

Question 4: Neptuneis considering reorganizing its machine setup operation into a separate unit and letting it charge CNC and MNC. The capacity for the machine setup operation is 120,000 setups a year. What should be the transfer price such that CNC and MNC would make decisions that maximize Neptune's interest? Be specific in your answer using data provided by the case. Explain.