ESTIMATING AND MANAGING COSTS AND REVENUES

1 and 2. 3. Information systems: theory and practice. How and why to estimate costs? Information systems and process complexity. Seligram case.

4 and 5.
6 and 7. 8.

Capacity resources and business cycles. SMT, Inc. case.

Activity-based costing. Coffee Services mini-case. Midterm.

9 and 10. Estimating and managing customer profitability. Infinity Bank case.

TACTICAL AND STRATEGIC DECISIONS

Capacity Management
Capacity has a cost, whether it is used or not

Capacity
Capacity is the maximum output or producing ability of a machine, person, factory, etc. Capacity can be measured in physical terms Measure of the amount of work done Capacity is the measure of the maximum amount of work that can be done in a given time

Capacity
Capacity = R * T R is the rate of output per unit of time T is the maximum amount of time available Capacity has a cost Cost to acquire or rent the facility, machine, operating costs, wages, utilities, insurance, etc. The cost is incurred even if capacity is underused

Measuring the Cost of Capacity

Traditional measures do not reflect the cost of capacity usage or over capacity Costs are part of overhead and allocated to production Focus is on inventory valuation, not managing capacity Allocation base is chosen from five alternatives Theoretical Maximum output when operating continuously at maximum efficiency

Measuring the Cost of Capacity

Practical Level of output under current conditions, allowing for normal downtime for setups, maintenance, vacations, etc. Normal Average level of output achieved or anticipated over several years Budget Level of output anticipated for the current year Actual Level of output actually achieved in the current year

Measuring the Cost of Capacity

Amount of capacity-related overhead charged to the output depends on the allocation base chosen
A stamping machine costs $400,000 per year to operate. The machine can produce 200 stampings per hour. The machine runs 24 hours per day. The company does not work on weekends (104 days) or holidays (10 days) Downtime for maintenance, setups, etc. averages 15 days per year. The machine is idle because of lack of materials for an average of 5 days per year. The equivalent of 8 days of production is lost each year because of defects produced by the machine. Management expects to produce an average of 1,000,000 stampings per year over the next five years. Planned output for the current year was 1,050,000 stampings. Actual output for the current year was 1,032,000 stampings, requiring 215 days. If successfully negotiated, a new contract with a customer would increase demand for the stampings by 24,000 units per year.
7

Measuring the Cost of Capacity

Traditional cost allocation measures Output Theoretical capacity Units per hour Hours per day Days per year Theoretical capacity Practical capacity Units per hour Hours per day Operating days per year* Practical capacity * 365-104-10-15-5=231 days Normal capacity Expected 5 year average output Budget capacity Planned output for the current year Actual capacity Actual output for the current year 200 24 365 1,752,000 Operating cost Cost per unit

* * =

$400,000

$0.228

* * =

200 24 231 1,108,800

$400,000

$0.361

1,000,000

$400,000

$0.400

1,050,000

$400,000

$0.381

1,032,000

$400,000

$0.388

Cost of Idle Capacity

Traditional Cost Accounting

The predetermined overhead rate is based on budgeted activity. This results in applying overhead costs of unused, or idle, capacity.

Activity Based Costing

Products are charged for the costs of capacity they use not for the costs of capacity they dont use.

Difference Between ABC and Traditional Product Costs

Batch-level or productlevel costs will ordinarily shift overhead costs from high-volume products produced in large batches to lowvolume products produced in small batches.

Under ABC both manufacturing and nonmanufacturing costs may be assigned to products. Organization-sustaining costs and the costs of idle capacity are not assigned to products.

10

Capacity
Capacity can be expressed in several ways, including: Total labor hours. Total machine hours. Total units of output.

11

Alternative Denominator-Level Concepts

Theoretical capacity

Practical capacity

Normal capacity

Master-budget capacity
12

Capacity
Theoretical Capacity: Maximum productive output possible over a given period of time. Practical capacity: Theoretical capacity reduced by normal, expected work stoppages. Normal capacity: Average annual operating capacity needed to satisfy expected sales demand.

Master-budget capacity: the expected level of capacity utilization for the current budget period
Excess Capacity: Extra machinery and equipment available when regular facilities are being repaired or when expected volume is greater.
13

Budgeted Fixed Manufacturing Overhead Rate

Lloyds Bicycles produces bicycle parts for domestic and foreign markets. Fixed overhead costs are $200,000 within the relevant range of the various capacity volume.

14

Budgeted Fixed Manufacturing Overhead Rate

Assume that the theoretical capacity is 10,000 machine-hours, practical capacity is 85%, normal capacity is 75%, and master-budget capacity is 60%.
What is the budgeted fixed manufacturing overhead rate at the various capacity levels?

15

Budgeted Fixed Manufacturing Overhead Rate

Theoretical 100%: $200,000 10,000 = $20.00/machine-hour Practical 85%: $200,000 8,500 = $23.53/machine-hour

Normal 75%: $200,000 7,500 = $26.67/machine-hour

Master-budget 60%: $200,000 6,000 = $33.33/machine-hour
16

Choosing a capacity level

Understand the major factors management considers in choosing a capacity level to compute the budgeted fixed overhead cost rate.

17

Choosing a Capacity Level

What factors are considered in choosing a capacity level?

Product costing Financial statements

Pricing decision Regulatory requirements

Performance evaluation

Difficulty

18

Decision Making

Assume that Lloyds Bicycles standard hours are 2 hours per unit.
What is the budgeted fixed manufacturing overhead cost per unit?

19

Decision Making

Theoretical capacity: $20 2 = $40.00

Practical capacity: $23.53 2 = $47.06

Normal capacity: $26.67 2 = $53.34

Master-budget capacity: $33.33 2 = $66.66

20

Explain how the capacity level chosen to calculate the budgeted fixed overhead cost rate affects the production-volume variance.
21

Effect on Financial Statements

Assume that Lloyds Bicycles actually used 8,400 machine-hours during the year.
What is the production volume variance?

22

Production Volume Variance

Production volume variance = (Denominator level Actual level) Budgeted fixed manufacturing overhead rate Theoretical capacity: (10,000 8,400) $20.00 = $32,000 U Practical capacity: (8,500 8,400) $23.53 = $2,353 U

23

Production Volume Variance

Normal capacity: (7,500 8,400) $26.67 = $24,003

Master-budget capacity: (6,000 8,400) $33.33 = $79,992

24

Death Spiral

Death spiral occurs when large fixed costs of a common resource are allocated to users who could decline to use that resource. As the allocated costs increase, some users choose to decrease use. Then the fixed costs are allocated to the remaining users, more of whom use less. This process repeats until no users are willing to pay the fixed costs. Possible solutions to death spiral: When excess capacity exists, charge users only for variable costs. Reduce the total amount of fixed costs allocated.

25 8-25

Death Spiral Example: Internal Services

Internal Telecommunications Department: Telecommunications service department allocates fixed costs to users. If some users are allowed to switch to outside phone company, the fixed costs allocated to remaining users increase. Eventually, the number of users of the telecommunications department is so small that the department is closed.

26 8-26

Death Spiral Example: Cost-based Contracts

Military Aircraft (not in text): Defense contractors working on advanced technology incur large fixed cost over-runs that are allocated to each aircraft manufactured. Government reduces number of aircraft purchased and that causes average cost to increase on remaining orders. Government responds by ordering even fewer aircraft. Eventually, the entire project is abandoned before all fixed costs are recovered.

27 8-27

Death Spiral in Reverse!

Clay Sprays: Increasing the allocation base for fixed costs can lead to misleading product line profit figures. Decisions should be consistent with an overall economic strategy and a meaningful understanding of the impacts of accounting practices. I left this to the accountants would not cut it in todays business environment.

28 8-28

PRIMARY CASE-STUDY OBJECTIVES

Illustration of decision-making pitfall: consequence of normal absorption costing; particularly dangerous in cyclical industries.

Intro to measuring and managing capacity resources: for decision support; to generate signals for management attention.

One solution: practical capacity approaches.

29

SMT OH RATES Sunnyvale Line 6

Sunnyvale Line 6 Annual OH Rates 1997 Budgeted line 6 OH (000s) Expected line 6 MHs OH Rate/MH 1998 1999 2000 2001

$ 2 512 $ 2 520 $ 2 696 $ 2 678 $ 2 768 4 380 7 008 7 183 5 256 3 504 $ 574 $ 360 $ 375 $ 510 $ 790

30

SMT MOTOROLA BIDS: 1999-2001

1999 OH Rate MHs/board OH allocation Direct materials: board SMDs Direct labor Cost per unit Quantity Order cost Markup (15%) Bid $ $ $ 375 $ 0.10 37.50 $

2000 510 $ 0.10 51.00 $ 0.14 $ 0.11 0.10 51.35 $ 22 000

2001 790 0.10 79.00 0.14 0.11 0.10 79.35 22 000

0.14 $ 0.11 0.10 37.85 22 000 $

$ $ $

832 700 $ 1 129 700 $ 1 745 700 124 905 169 455 261 855 957 605 $ 1 299 155 $ 2 007 555

31

PROJECT HP-HDC-32

Selling price = $107. Annual volume about 10 000. Materials content $1.32. Labor $0.31. Processing requirements 0.2 MHs / unit. Profitability of this contract from 1999 - 2001?

32

PROJECT HP-HDC-32
1999 MHs per unit OH Rate $ OH allocation $ DM DL Product cost $ Price $ Profit/unit $ Annual volume 0.2 375 $ 75 $ 1.32 0.31 77 107 30 10 000 $ $ $ $ 2000 0.2 510 $ 102 $ 1.32 0.31 104 107 3 10 000 33 700 $ $ $ 2001 0.2 790 158 1.32 0.31 160 107 (53) 10 000 $ (526 300) $ 1 070 000
33

Annual profit $ 303 700 Annual revenues $ 1 070 000

$ 1 070 000

MACRO, INDUSTRY, COMPETITION, OTHER REASONS

SALES VOLUMES

PRICES ? CUT PRODUCTS?

OH COSTS DO NOT DECREASE AS FAST AS VOLUMES

OH RATES REPORTED PRODUCT COSTS

34

EXAMPLE

Current operations

12,000,000 10,000,000 8,000,000 6,000,000 4,000,000 2,000,000 0

00

00

00

00

00 1, 8

20

40

60

80

1, 0

1, 2

1, 4

1, 6

UNITS
35

2, 0

00

EXAMPLE

2,000 Units Forecast. 10,000,000 / 2,000 = 5,000 Cost Per Unit Competitor enters our market; we lose 700 units, expect 1,300 units next year. 1,300 Units Forecast. 10,000,000 / 1,300 = 7,692 Cost Per Unit Problems?

36

EXAMPLE: OVERHEAD ESTIMATION USING PRACTICAL CAPACITY 5,000 COST PER UNIT REGARDLESS OF EXPECTED PRODUCTION

12,000,000 10,000,000 8,000,000 6,000,000 4,000,000 2,000,000 0

00

00

00

00

00 1, 8

20

40

60

80

1, 0

1, 2

1, 4

1, 6

UNITS
37

2, 0

00

EXAMPLE: OVERHEAD ESTIMATION USING PRACTICAL CAPACITY 5,000 COST PER UNIT; 1,300 UNITS FORECAST

12,000,000 10,000,000
3.5 Million

8,000,000 6,000,000 4,000,000 2,000,000 0

EXCESS capacity 6.5 Million USED capacity

00

00

00

00

00 1, 8

20

40

60

80

1, 0

1, 2

1, 4

1, 6

UNITS
38

2, 0

00

SMT: OH RATES WITH PRACTICAL CAPACITY

1997 Line 6 overhead Practical capacity (MHs) OH Rate / MH $ 2,512,000 7,066 $356

1998 $ 2,520,000 7,014 $359

1999 $ 2,696,000 7,186 $375

2000 $ 2,678,000 6,986 $383

2001 $ 2,768,000 7,256 $381

39

BIDS WITH PRACTICAL CAPACITY RATES

Motorola bid MOT-F-23 1999 OH Rate MHs/board OH allocation Direct materials: board SMDs Direct labor Cost per unit Quantity Order cost Markup (15%) Bid $ 375 $ 0.10 37.50 $ 0.14 $ 0.11 0.10 2000 383 $ 0.10 38.30 $ 2001 381 0.10 38.10 0.14 0.11 0.10 38.45 22 000

$ $

0.14 $ 0.11 0.10 $

37.85 $ 38.65 22 000 22 000

$ 832 700 $ 850 300 $ 845 900 124 905 127 545 126 885 $ 957 605 $ 977 845 $ 972 785
40

EXCESS CAPACITY REPORTS

Sunnyvale Line 6 Capacity Analysis (Forecasts) 1997 1998 1999 2000

2001

Good production Practical capacity

Utilization % Excess capacity: Machine hours Rate Excess capacity

4 380 7 066
62%

7 008 7 014
100%

7 183 7 186
100%

5 256 6 986
75%

3 504 7 256
48%

2 686 356

$ $

6 359 2 154

$ $

3 375 1 125

1 730 383

3 752 381

$ 956 216

$ 662 590

$ 1 429 512

41

ACTIONS TO MANAGE EXCESS CAPACITY

FILL EXCESS CAPACITY: New products, services; New customers; New business models; In-source items currently outsourced; Use for training, newproduct development; Marginal business; Aggressive pricing.

REMOVE EXCESS CAPACITY: Sell assets; Temporarily reduce capacity.

42

PRACTICAL CAPACITY ADVANTAGES

1. 2.

Avoids the death spiral; Generates signals about our capacity utilization;

3.
4.

Avoids wild fluctuations in OH costs;

Products do not incorporate the cost of our inefficient capacity utilization. Remaining problem still doesnt tell us: i. why we have excess capacity;

ii. how to determine the right level of excess capacity; iii. how to get to that level.
43

KEY TAKEAWAYS SMT

Standard OH allocation techniques introduce a common decision pitfall when industry or macroeconomic conditions change. The death spiral is a dangerous consequence of relying on budgeted capacity utilization to allocate costs. Practical capacity is a solution to the death-spiral problem.

In addition, practical capacity approaches generate valuable signals about underutilized capacity.

44