A graph demonstrating the variation between the product cost computed with the current CAS and the new activity-based system is shown in Figure 4. As you can see, the current system significantly undercosts product 101 and overcosts products 102 and 103. Figure 5 illustrates that current CAS significantly under-allocates overhead cost to product 101 and over-allocates cost to product 102 and 103.
Under the current CAS, ACC thought they were obtaining planned gross margin on product 101, but not on product 102 or 103. However, the new ABC system shows significantly different results. ACC’s new gross margins on the three products are -55%, 22%, and 42%.
The lesson to be learned is that ACC’s current CAS does not account for product complexity as shown in the previous section. Under the current system, ACC thought it was achieving the greatest return on product 101, when in fact this product has the lowest contribution. Product 101’s gross margin changed from 20% to -55% when costs were computed using the new cost drivers. The large difference between product cost is attributable to product 101’s low direct labor content and its high transaction volume. The direct labor is less than product 103 while it requires a greater amount of transactions than the other two parts. Due to the products similar direct labor content, the current CAS allocated basically the same amount of
overhead to each of the three products. No differentiation was made between products which required greater resource utilization under the current CAS.
ACC’s Current CAS
Is ACC beginning to show signs of a faulty cost system? The answer to this question is definitely yes. The first indication is that the investment ACC has made in new flexible technology has not increased profits. In fact, ACC’s margins have been declining, while the small volume orders which were believed to be profitable have been increasing. With the new ABC data, that ACC has been targeting the wrong customers becomes clear. The small volume parts are generally more complex and require the use of more overhead resources. Product 101 has the most runs,
shipments, components, and movement. Unfortunately, the current CAS does not account for this complexity. Product 102 and 103 turn out to be ACC’s biggest breadwinner. They are both higher volume products which require less resource consumption.
Strategy
With the new information provided by the ABC system, ACC can begin to regain sales growth and gross margins. In the short run, the price of product 101 should be raised. Not surprisingly, ACC’s customers may not challenge this move. The ABC costs show product 101 is achieving a negative gross margin. That ACC customers are well aware of this fact and would not be able to purchase the part elsewhere for the same amount is quite possible. Therefore, ACC’s customers may give them quite a bit of leeway on the product’s price. A price increase would soften the blow ACC is taking each time they sell product 101.
In the long run, ACC will be able to use the ABC information to reallocate their resources and move towards a more profitable product mix. The activity-based information can be used to reduce many non-value adding activities. The resulting freed up resources can then be reallocated to value adding activities. Some
examples are presented below.
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Factory Layout—The current layout of the factory is inefficient. Referring to Figure 5 in the case, Product 103 is routed throughout the factory from the receiving to shipping in a fluid pattern. Consequently, the total distance material must be moved is 250 feet per run, versus 350 feet per run for product 102, and 500 feet per run for products 101. Products 101 and 102 are not routed as efficiently. These products must be moved randomly throughout the factory. Consequently, they also require more runs. The result is that ACC spends the bulk of its material movement time on smaller volume specialty products. The new ABC system draws attention to this problem by penalizing products 101 and 102 with more material movement cost.
Managers can easily identify this problem with the new ABC information and execute corrective action in the future.
Components—In the long run, ACC can reduce the components per part by
producing simpler designs. ACC’s design engineers have been inadvertently adding cost to products by simply increasing the number of components per part. Each time a new component is added to a part, a wide array of activities are influenced. Not only must the new part be designed by the product engineers, it must also be tested, routed through the factory, inspected, improved and shipped. These activities add costs to a product which an engineer simply cannot foresee when designing a part.
Product 101 has 16 components and is responsible for 30.7% of the engineering cost under the new ABC system, yet it accounts for only 16.7% of the total volume.
Setup Time—A reduction in setup time can lead to increased plant flexibility. As setups are reduced, it is possible to run smaller batch sizes more often or reallocate setup resources to other activities. In the long term, layoffs should not occur
because the extra resources should be reallocated to value added activities such as production or continuous improvement.
Runs and Shipments—ACC needs to be aware that costs increase with the number of runs and shipments. However, ACC should not immediately tell customers they will not be supplying small volume orders anymore. Supplying orders in small volume can be a competitive advantage, providing that service adds value for the customer, and ACC should be compensated for that value by requiring a higher price.
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