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CASE 1

Mechanical City
Activity-Based Costing (ABC)

Mechanical City manufactures electronic testing and measurement instruments. Many


products are custom-designed with recent orders for function generators, harmonic
analyzers, logic analyzers, temperature measurement instruments, and data-logging
instruments. The company prices its instruments at 30 percent over estimated cost
(excluding administrative and selling costs).

Recently, senior management has noted that its product mix has changed. Specifically,
the company is receiving fewer large orders for instruments that are relatively simple to
produce, and customers are saying that the company is not price competitive. The
company is, however, receiving more small orders for complex instruments, and
customers appear quite happy to pay Mechanical City’s price. The situation was
discussed at a weekly management meeting. Vinson Kompany, VP of operations, blamed
the company’s antiquated cost accounting system. “Look,” he said, “if you have bad cost
information, you’re going to have bad prices, and we’re still doing product costing the
way companies did it in the 1930s. I’ve been reading articles about activity-based costing,
and they indicate that out-of-date costing systems make simple products look too costly
and complex products too cheap. If that’s true, it would explain why we’re not price
competitive for simple products.”

The meeting ended with a decision to hire a consultant to conduct a preliminary ABC
study to determine how a switch to ABC would affect product cost. The consulting firm
selected two recent orders for study: a 900-unit order for a temperature-monitoring
device and an order for 1 harmonic analyzer. The cost and prices charged were as follows:

Temperature Harmonic
Monitor Analyzer

Component cost per unit $ 250 $ 2,500


Direct labor per unit 25 500
Overhead per unit 120 2,500
Cost per unit 395 5,500
Markup at 30% 119 1,650
Price per unit 514 7,150
Number of units 900 1
Value of order $ 462,600 $ 7,150
In the current system, overhead is applied based on an estimate of $50,000,000 of annual
overhead and $10,000,000 of direct labor cost. The consultants have broken the
$50,000,000 of annual overhead down into six cost pools and identified related cost
drivers as indicated in Exhibit 1. The consultants have also found that the monitor and
analyzer make use of the cost drivers as indicated in Exhibit 2.

Exhibit 1: Cost pools and drivers


Cost Pools Annual Cost Annual Driver Volume
Product design $ 8,000,000 160,000 design hours
Material ordering and handling 10,000,000 125,000 unique parts
Inspection 3,500,000 560,000 inspections
Setup 2,500,000 80,000 setups
Labor-related overhead 8,000,000 $10,000,000 direct labor
Depreciation of plant and equipment 18,000,000 225,000 machine hours
$ 50,000,000

Exhibit 2: Use of cost drivers


The following values The following values
relate to the entire order relate to the order of 1
of 900 monitors (this is analyzer:
not per monitor):

Number of design hours 47 110


Number of unique parts 17 25
Number of inspections 225 20
Number of setups 1 1
Machine hours 112 7

Required:

1. Based on the consultants’ work to date, calculate the ABC cost per unit of monitor and
analyzer.

2. The consultants have completed their job, and Mechanical City has adopted an ABC
system as indicated in Exhibit 1. Recently, the company received an order for a unique
data-logging device. The device will require $9,000 of components and $3,000 of direct
labor along with the following requirements:

Use related to a data logging device:

Number of design hours 22


Number of unique parts 15
Number of inspections 10
Number of setups 1
Machine hours 10

The customer has indicated that it currently has a low bid from another company of
$20,000. Calculate the ABC cost of the data-logging device.

3. Suppose Mechanical City meets its competitor’s price and gets the job. What will be
the impact on company profit? In answering this question, make following assumptions:

a. 60 percent of design costs are fixed, and 40 percent vary with design hours

b. 70 percent of material ordering and handling costs are fixed, and 30 percent vary
with number of unique parts.

c. 40 percent of inspection costs are fixed, and 60 percent are variable.

d. 60 percent of setup costs are fixed, and 40 percent are variable

e. 20 percent of labor-related costs are fixed, and 80 percent are variable.

f. Prices charged to this customer or other customers in the future will not be
impacted by the current deal. This follows because each order is somewhat unique.