From the basic allocation method to the to cost-pools (homogeneous departments) to Activity Based Costing.
The Electrochic company case study
First part: the initial situation and the first proposal N°1
Electrochic was founded by Mr Bigshot in 1985 and initially manufactured top quality ( upmarket) chip pans. These appliances were for consumers and small businesses for professional use. The company had acquired a good corporate image due to the top quality of its products. Unfortunately, for Mr Bigshot, the chip pan market has gradually declined and entered its maturity stage and the advertising campaigns concerning the prevention of heart disease have not helped matters.
Therefore, the company decided to expand its range of products and look for new market segments (new axes). In order to implement this new strategy they employed the services of a consultant specialized in strategy who drew the following conclusions: “your core competence is in small electrical domestic appliances.” You could use your competences with a view to expanding your range in similar products as you could already use the experience you have acquired.
So Electrochic has developed a range of irons and robot mixers. The synergies as far as production is concerned are obvious. In fact, the three product lines use the same machines and the same manpower. On the other hand, as far as the sales force is concerned, considerable efforts had to be undertaken in order to ensure the distribution of new products. As a matter of fact, the Electrochic chip pans are still sold via one distribution chain. Irons and robot mixers need a larger market. Contracts were signed with other distributors with a view to guaranteeing outlets for the new products;
Thanks to investment in production the production process was improved and modernized. The products are assembled with spare-parts bought from outside suppliers. Delivery to the customers is on a J-I-T basis.
In 2010, the chip pans only represented 23% of the turnover. In this segment, Electrochic continued a niche marketing strategy. It has only one customer. The manufacturing only consists of 2 cycles of production per month. The chip pans are assembled with 8 components bought from outside suppliers.
The iron market is characterised by strong intensive competition. Firms are struggling to compete against each other by reducing the price. Electrochic is obliged to follow suit. Five components are used for the manufacturing of irons. There are 6 production cycles per month.
The robot mixers represent , a more complex product which is composed of more components. The company offers different models which are not sold to the same customers. Twelve cycles of production have to be implemented each month. This segment seems to be less competitive, this explains why Electrochic has recently increased the prices of its robot mixers without having had a decrease in the number of orders.
In appendix one there is some information on the three products and on the structure of the cost allocation.
The market for irons is a particularly worrying issue for top management at Electrochic. Indeed, the competitors are regularly lowering their prices and the company has to follow suit. It does not really have a choice. Are the competitors selling at a loss ? Or is Electrochic less effective even though it has modernized production? Is the diversification strategy into the market of irons pertinent? Mr Bigshot, CEO of Electrochic, decides to hold a meeting with his main collaborators, Mr Check, the Control Manager, Mr Costcut, Production Manager and Mr Totalsum, the Sales Manager, with a view to gathering information and brainstorming their viewpoints on the question.
Mr Costcut: “ I wonder how our competitors manage to continue lowering their prices for irons! We have a new production system which is very efficient and I doubt that their productivity is better than ours.”
Mr Totalsum: “This is all very unnerving especially as there seems to be a certain number of rival companies.We will reach a monopolistic or oligopolistic situation. Even if certain companies are exiting the market due to the price war, it is highly unlikely that there are only two or three left to share the market. In any case, it is in no-one’s interest to sell at a loss! So why are the others lowering their prices?
Mr Check: “Are our competitors making different hypotheses on our cost allocations or are they allocating them differently among their products. Or they have forgotten that the selling price must allow enough margin to cover the cost allocations and make profits”.
Mr Bigshot: “Yes, I remember that last month , you offered a new method which would entail the sharing out of the indirect expenses. I told you that changing methods represents a cost. And then, I am rather worried by the discontinuity in our data record which this would imply.
Mr Check: “It is true that your current system is very easy. For each product, we determine a direct cost tracing, made up of raw materials and manpower( of production and launching). The total of the indirect costs is split between the products depending on their function and the cost tracing of manpower.
I wonder if this system is still pertinent? Our indirect costs have tended to increase during the last few years. This is due to the fact that, we have automated our production system; which has increased our direct labour and depreciation costs. Besides, the models were innovated more rapidly and we had to develop an important promotional activity in retail outlets. This is why it seems necessary to adopt a method which is more rigorous in order to deal with the cost allocation.
This is what has led me to study another approach. I think that we could split the company into various cost pools by using the structure in our organisation chart: there are 6 departments, 3 involved in production ( assembling, finished products and maintenance ), 2 for the commercial aspect (marketing and distribution) and one regrouping the administration and the CEO. For each of these homogeneous cost pools, it is necessary to determine a way of implementing this. For each of these departments we are looking at how to separate each activity in the most advantageous way For each of the cost pools, we will determine the labour costs per unit and if we do not find a feasible solution we will divide the indirect costs into a rate of expense. (appendix 2)
Mr Bigshot: Do you really believe that this method once it is implemented will not turn out to be more expensive than the current one?
Mr Check: “Not at all. Besides we dispose of all the elements to calculate the cost price of our different products according to the new approach.
You are the control manager . He asks you to determine the cost price and the margins of each product. First using the basic allocation method and the cost pool method which Mr Check is suggesting. We also expect you to analyse the various results.
Second part: Proposal 2
After the analysis Mr Bigshot holds another meeting with his collaborators to analyse the final results.
Mr Costcut: “ With this method the robot mixers remain more or less profitable and the margin on irons improves quite a bit. On the other hand it is a catastrophe for the chip pans as for each unit sold there is a small loss. It seems quite obvious that it is in our interest to concentrate our efforts on robot mixers.”
Mr Bigshot: “I am not as sure about this. In any case, our cost price depends on how we allocate the direct costs. This is quite unnerving! However, we do need reliable information to fix our selling price and know which products are profitable in order to determine which ones we should develop.
Mr Totalsum : “ I am not an expert as far as costs are concerned but it is important that we find out how much is spent on the resources used in the production costs. A few weeks ago I attended a seminar at HEC-ULG. I was informed about a new method. I haven’t really fully-understood what the Professor was talking about because it is not really my field. But the general idea is: it is the operations themselves which are at the origin of the costs. As far as I’m concerned as I am in charge of production, this idea seems to be the key point. The operations are the central issue. « reception and handling of components », « packaging and delivery, » and « maintenance »: We could allocate the costs to the different products and calculate how much each product costs as far as the operations are concerned.”
Mr Check : “Yes, I have also read quite a bit in magazines specialized in ABC . Why not try this new method? We would need to meet again to identify the operations and how much each operation costs.”
Mr Bigshot, Mr Costcut and Mr Totalsum show you the results of their search in appendix 3
Bearing in mind these new figures which calculate the cost price and the marginal units of the three types of products we would like you to compare the results with the initial figures.
What do you think? Which method seems the most pertinent and why?
Which are the pros and cons of each method of allocating indirect costs?