Reference no: EM131059147

Avctivity Based Costing

Background

Founded in 1952, LEHIGH manufactures and sells earthing strips to electronic companies. Earthing strips are brass plates used to connect wires to grounding circuits.

LEHIGH has grown steadily, averaging 8% growth in sales per year since 1952.  The company has been profitable in every year of its existence, although company profits as a percentage of sales has grown more slowly than sales in recent years.  Profits as a percent of sales in the early sixties exceeded 20%.  Current profit as a percent of sales is 9%.

Lead time from receipt of customer order to shipment is 3 weeks.  Originally a one product company, LEHIGH now sells three earthing strips, Alpha, Beta, and Gamma, to cover a wide range of customer applications.  It is believed that all three products are profitable.

Corporate Vision

To be the dominant supplier of earthing strips.

Competitive Situation

Until recently, LEHIGH's main competition came from a small number of companies.  These companies sell a full line of earthing strips at prices that match LEHIGH.  No single company has a dominant position in the marketplace.

This stable situation threatens to change with the entry of ROYAL CORPORATON into the marketplace.  A major trading company, ROYAL has introduced a single earthing strip (comparable to LEHIGH's Alpha product) at a price 25% below prevailing market prices. ROYAL is offering a customer lead time of 2 weeks or less.

While LEHIGH has not experienced a weakening of its sales growth, it has lost two key accounts to ROYAL.  Investigation by the marketing department revealed that price was the key factor in the loss of the accounts.  A contributing factor was customer dissatisfaction with the long order lead times.

Competitive Response

The entry of ROYAL, and the loss of the key accounts, prompted a wide-ranging review of the company's strategic tactical options.  A market research study revealed that customers bought the Beta and Gamma products because their price was lower than that of the Alpha, but not to satisfy specific product requirements.  Other than price, they would have been satisfied with the Alpha.

The engineering department confirmed the results of the market study.  Tests show that the Alpha can always be substituted for the Beta, and frequently, but not always, the Gamma.

According to the company's standard cost system, the cost of the Alpha exceeds that of the other two products.

Activity-Based Costing and Activity-Based Management

LEHIGH's management team is unwilling to proceed with any option without acquiring additional information.  Management believes that the standard costs of the earthing strips are inaccurate, and do not provide a sound basis for product mix or pricing decisions.

Management is also unable to pinpoint areas of high cost.  They also cannot assess the potential for cost reduction.  The existing financial and operating information is inadequate for this purpose.

Your management team is now taking Lehigh's Cost Accounting course (and enjoying it).  You therefore believe that ABC and ABM could help provide the answers management needs. After some discussion, management agreed to implement ABC and ABM.

Important Information

                                             Alpha             Beta             Gamma          Total

#Customer orders                   800               1,000           1,200             3,000

#Parts manufactured               12,000           10,000         8,000             30,000

#Work orders                         95                  85               120               300

#Die changes                          95                  85               120               300

Machine hours/unit                  1.0                 0.7               0.5

Materials $/part                       $10.00           $6.00            $4.00

Labor hours/part                     1.0                0.7                0.5

Labor rate/hr.                                                                                      $15.00

Competitor's price                                                                                $45.00

Price/part                                $60.00          $40.00           $30.00

Direct labor                                                                                          $345,000

Indirect labor                                                                                        $500,000

Facilities                                                                                               $75,000

Total conversion costs                                                                           $920,000

Resources

Direct labor

Engineering analysis shows that 60% of the time is spent changing dies.  The rest of the time is devoted to production.  Dies are stored in a locked cage 500 feet from the machining equipment.  Only supervisors have keys.  The average time spent getting the die from the die cage is 1 hour, plus ½ hour waiting for the supervisor.  Two hours are spent installing, adjusting, and testing the die setup.  Total cycle time for changing a die is 6 hours.  Inspection of the first parts of each batch reveals that the dies require additional adjustment 50% of the time.  Die adjustment requires a variety of hand tools which are in a small tool box in the center of the machining area.

When a lot is complete, it is placed in bins and moved to the inspection area daily.

Indirect labor

Interviews with indirect staff revealed the following work patterns:

Activity                                  # of staff

Processing orders                       4

Scheduling orders                       4

Changing dies                             7

Inspecting lots                            3

Shipping product                         2

Total # of staff                            20

All orders are batched daily and entered into the production control system.  Review, approval, and correction, generally required 1 day.  An order cannot be scheduled until the materials have been received. Lead time for materials is 4 days.  Lots are inspected on a first come, first served basis except for late orders.  Average time spent in inspection and disposition is 3 days.  Shipments are packed and carrier pickup arranged within 2 days.  Motor freight averages 4 days to the customer.

Facilities

A survey of space utilization revealed the floor space occupied by each activity:

Activity                            Square Feet

Processing orders                      2,000

Scheduling orders                      2,000

Changing dies                          12,000

Punching dies                          16,000

Inspecting lots                            4,000

Shipping product                        4,000

Total square feet                      40,000

REQUIREMENTS:

Traditional Costing

1.   Each group is asked to determine the profit margin per unit for each of the three products, as reported by LEHIGH's traditional cost system.  The traditional cost computation included (1) direct materials cost, (2) direct labor cost, and (3) overhead. Overhead was applied based on direct labor hours.

2.   Explain why the cost differs for each product.

3.   Explain whether or not it is possible to drop the price of the Alpha to compete.

4.   Based on your analysis, explain whether LEHIGH can focus only on two products.

Activity-Based Costing

1.   Determine the profit margin per unit for each of the three products, using ABC.  The ABC cost computation should include two cost categories:

a.    Direct materials cost

b.    Conversion costs:  combine labor and overhead

2.   Use the information to explain why the ABC costs differ from the traditional method.

3.   Explain to what extent the ABC costs change your mind about repricing the products.

4.   Using ABM, what cost management suggestions can you suggest to improve the LEHIGH Corporation?  Give specific examples.