Dakota Motors produces electric motors for commercial use. Until the end of 1994, only 2 models were produced, the âStandardâ modelâ and the âDeluxeâ model. The Deluxe model had more expensive components and raw materials, required more quality control and required more labor hours per unit to produce than the Standard model. Both models were produced in fairly large volume. Since 1994, in an attempt to grow its business, and in response to competitive pressures, Dakota Motors has begun producing many different varieties of electric motors, in addition to its regular models. These new models are tailor made to the needs of individual customers and are produced only on demand, and are typically low volume lines.
Dakota Motors has a simple (traditional) costing system which traces the costs of direct materials, components, and direct labor to each of its product lines. All support costs are assigned to product lines via a single plant wide overhead rate based on direct labor hours. Its volume of manufacturing activity has grown from 20,000 direct labor hours in 1994 to 30,000 direct labor hours in 1997.
Dakota Motorsâ accounting system is reporting a rapid escalation in the costs per unit of producing the Standard and Deluxe models. Management is puzzled and vexed by these cost increases, since the prices of various production inputs (such as labor, raw materials, components, engineers, supervisors, etc.) have increased only marginally during these years, and the production methods for producing the Standard and Deluxe models have not changed.
Below, is data regarding support activities, annual support costs and driver volumes:
Support Costs Support Activity Cost driver 1994 1997 Supervision Direct labor hours $144,000 $220,000 Machine maintenance Machine hours $ 80,000 $140,000 Quality control # of inspections $ 40,000 $100,000
Machine set ups # of setups $ 20,000 $120,000 Process engineering Engineering hours $ 10,000 $150,000 Total support costs $294,000 $730,000
Standard Deluxe New Models Total Direct labor hours 12,000 8,000 10,000 30,000 Machine hours 14,000 12,000 14,000 40,000 # of inspections 400 400 600 1400 # of setups 11 9 100 120 Engineering hours 120 140 1,740 2,000
Assume that the production quantities and driver volumes for the Standard and Deluxe models have not changed between 1994 and 1997.
Questions:
1) Determine the total support costs assigned to the Standard model and to the Deluxe model in 1994 and in 1997 under the traditional costing system.
2) Calculate the cost driver rates and determine the support costs that would be assigned to the Standard, Deluxe and New models in 1997 under an activity based costing system. Be sure to display and label all your calculations.
3) Write a paragraph explaining to top management how the traditional costing system distorts product costs in Dakota Motors. Use the data on engineering hours and direct labor hours to quantitatively support your argument.
Dakota Motors produces electric motors for commercial use. Until the end of 1994, only 2 models were produced, the âStandardâ modelâ and the âDeluxeâ model. The Deluxe model had more expensive components and raw materials, required more quality control and required more labor hours per unit to produce than the Standard model. Both models were produced in fairly large volume. Since 1994, in an attempt to grow its business, and in response to competitive pressures, Dakota Motors has begun producing many different varieties of electric motors, in addition to its regular models. These new models are tailor made to the needs of individual customers and are produced only on demand, and are typically low volume lines.
Dakota Motors has a simple (traditional) costing system which traces the costs of direct materials, components, and direct labor to each of its product lines. All support costs are assigned to product lines via a single plant wide overhead rate based on direct labor hours. Its volume of manufacturing activity has grown from 20,000 direct labor hours in 1994 to 30,000 direct labor hours in 1997.
Dakota Motorsâ accounting system is reporting a rapid escalation in the costs per unit of producing the Standard and Deluxe models. Management is puzzled and vexed by these cost increases, since the prices of various production inputs (such as labor, raw materials, components, engineers, supervisors, etc.) have increased only marginally during these years, and the production methods for producing the Standard and Deluxe models have not changed.
Below, is data regarding support activities, annual support costs and driver volumes:
| Support Costs | |||
| Support Activity | Cost driver | 1994 | 1997 |
| Supervision | Direct labor hours | $144,000 | $220,000 |
| Machine maintenance | Machine hours | $ 80,000 | $140,000 |
| Quality control | # of inspections | $ 40,000 | $100,000 |
| Machine set ups | # of setups | $ 20,000 | $120,000 |
| Process engineering | Engineering hours | $ 10,000 | $150,000 |
| Total support costs | $294,000 | $730,000 | |
| Standard | Deluxe | New Models | Total | |
| Direct labor hours | 12,000 | 8,000 | 10,000 | 30,000 |
| Machine hours | 14,000 | 12,000 | 14,000 | 40,000 |
| # of inspections | 400 | 400 | 600 | 1400 |
| # of setups | 11 | 9 | 100 | 120 |
| Engineering hours | 120 | 140 | 1,740 | 2,000 |
Assume that the production quantities and driver volumes for the Standard and Deluxe models have not changed between 1994 and 1997.
Questions:
1) Determine the total support costs assigned to the Standard model and to the Deluxe model in 1994 and in 1997 under the traditional costing system.
2) Calculate the cost driver rates and determine the support costs that would be assigned to the Standard, Deluxe and New models in 1997 under an activity based costing system. Be sure to display and label all your calculations.
3) Write a paragraph explaining to top management how the traditional costing system distorts product costs in Dakota Motors. Use the data on engineering hours and direct labor hours to quantitatively support your argument.
Related questions
INSOURCING/OUTSOURCING
Rentex Motor Drives is a division of a large U.S. manufacturer of industrial machinery and equipment. The parent company makes circulating pumps, high-capacity cooling fans, and compressors. Rentex Motor Dnves manufactures the electric motors that power much of this machinery and equipment. Rentex has a world-wide customer base and sells motors not only to its parent company, but also to other customers across the globe â some of whom are direct competitors of Rentex's parent company.
Recently the company developed an electric motor assembly that will be a key component in a new circulating pump being manufactured and sold by one of Rentex's sister companies. The circulating pump will be sold to the manufacturers of oil-fired burners used for home heating. Each circulating pump will require a single electric motor assembly.
Rentex must now decide whether or not it should outsource or internally manufacture the motor assembly. To help with the analysis, a cross-functional team has been formed. Members of the team have been assigned the responsibility of analyzing from a total cost perspective whether or not Rentex should outsource or internally manufacture the electric motor assembly.
A European supplier that produces motors for a number of Fortune 500 companies has submitted a detailed proposal to Rentex for building the subassembly. However, confounding this analysis is an internal bias against outsourcing the motor, particularly since there is a strong union presence within Rentex's facilities. Furthermore, management at Rentex believes that the electric motor assembly design might be adapted in the future to enable its use in new applications in the chemical processing industry, thereby representing a future growth opportunity.
As an initial step the cross-functional team has gathered the required information to guide the firm's decision process.
Outsourcing Costs
Unit Costs: Rentex's marketing group estimates that volumes for the motor assembly are:
| Year 1 | 5,500 units |
| Year 2 | 6,250 units |
| Year 3 | 7,000 units |
The European supplier of electric motors has quoted a price of $105 per unit, FOB ex-works, 1&2 with 5% price decreases per year for Year 2, and again for Year 3. Remember â the Year 3 price decrease is based off the Year 2 figure). The team assumes these price decreases are due to productivity improvements from higher volumes, the positive effects of learning at the supplier, and greater operating efficiencies. These prices have not been negotiated and the purchasing team believes that negotiation may lead to a lower unit price. If the new line of circulating pumps is successful, it is estimated that the life of the product cycle will be six years, reaching a peak of 8,000 units in Year 4, with a 10% reduction per year in volume after that as the product reaches the end of its life. It is estimated that the product will be completely phased out at the end of Year 6.
Shipping, handling, and receiving: Shipping, handling, and receiving costs at the buyer are estimated to be $15 per unit and should remain constant.
Tooling: The supplier has stated that it will cost $30,000 to fabricate the tooling and fixtures required to produce the electric motor. Rentex's policy is to assume ownership of tooling, so Rentex is responsible for the tooling costs. It's estimated that the tooling will have a usable life span of at least 6 years, with proper preventive maintenance (which the supplier has agreed to perform at no additional cost). The purchasing team plans to allocate the tooling costs evenly over the first three years.
Quality-related costs: The team has decided to include quality-related costs in its outsourcing calculations. During the investigation of the supplier, a team member collected data on the process that would likely produce the motors. The team estimates that the supplier's defect level, based on process measurement data, is 1,000 parts per million (ppm). Rentex's quality assurance department estimates that each supplier defect will cost Rentex $1,750 in direct nonconformance costs. Unfortunately, with quality problems there are always hidden costs that are difficult, if not impossible, to model.
Supplier capacity/safety stock: The team has concluded the supplier has available capacity to satisfy Rentex's current and near-term requirements for the motor. To mitigate supply chain risk, Rentex plans to hold one month's worth of the assembly as safety stock. The team assumes that this is a new cost each year.
Insourcing Costs
Rentex's cost engineering department has provided the following per unit cost estimates for internally manufacturing and assembling the motors during Year 1 of a three-year planning cycle:
| Direct labor | $19.75 | Cost of receiving components | $4.25 |
| Direct materials | $35.25 | Supplemental factory supplies | $2.15 |
| Transfer profit 3 | $21.75 |
Initial tooling and line modification costs: The start-up costs (including tooling) to modify existing production lines and equipment to accommodate production of the new motor will be $42,000, which will be spread out evenly over the first three years.
Depreciation expense: Depreciation expense on production equipment and tooling is considered a noncash item and is not included in the insourcing analysis.
Engineering design costs: Engineering costs to design, develop, and improve the production process will be $75,000 and will be spread evenly across the first three years of production.
Factory and corporate overhead: Overhead is allocated at 180% of direct labor costs.
Cost increases: In Years 2 and 3, management expects a 2% annual increase in direct material costs and a 3% increase in direct labor rates. (This increase is compounded so the increase in Year 3 costs is based off Year 2 cost figures).
Quality-related costs: The team estimates that Rentex's finished electric motor quality defects to be 2,500 ppm. Rentex's quality assurance department estimates that each defect costs the company $1,500 in nonconformance costs.
Preventive maintenance costs: Rentex's maintenance manager estimates that preventive maintenance of the production equipment required to produce the motors will cost $15,000 in Year 1, and will increase at the rate of 3% per year thereafter.
NOTES:
1. FOB (free on board) vessel means the supplier is responsible for transportation charges to the port in China.
2. Buyer is responsible for the cost and delivery of goods from the seller's location.
3. Transfer profit is the internal profit from selling to another unit in the company. This company views its units as profit centers, so profit must be included. Furthermore, the supplier has included profits in its quoted price.
Calculate the total cost per year for insourcing and outsourcing. Also calculate the cost per unit.
INSOURCING/OUTSOURCING
Rentex Motor Drives is a division of a large U.S. manufacturer of industrial machinery and equipment. The parent company makes circulating pumps, high-capacity cooling fans, and compressors. Rentex Motor Dnves manufactures the electric motors that power much of this machinery and equipment. Rentex has a world-wide customer base and sells motors not only to its parent company, but also to other customers across the globe â some of whom are direct competitors of Rentex's parent company.
Recently the company developed an electric motor assembly that will be a key component in a new circulating pump being manufactured and sold by one of Rentex's sister companies. The circulating pump will be sold to the manufacturers of oil-fired burners used for home heating. Each circulating pump will require a single electric motor assembly.
Rentex must now decide whether or not it should outsource or internally manufacture the motor assembly. To help with the analysis, a cross-functional team has been formed. Members of the team have been assigned the responsibility of analyzing from a total cost perspective whether or not Rentex should outsource or internally manufacture the electric motor assembly.
A European supplier that produces motors for a number of Fortune 500 companies has submitted a detailed proposal to Rentex for building the subassembly. However, confounding this analysis is an internal bias against outsourcing the motor, particularly since there is a strong union presence within Rentex's facilities. Furthermore, management at Rentex believes that the electric motor assembly design might be adapted in the future to enable its use in new applications in the chemical processing industry, thereby representing a future growth opportunity.
As an initial step the cross-functional team has gathered the required information to guide the firm's decision process.
Outsourcing Costs
Unit Costs: Rentex's marketing group estimates that volumes for the motor assembly are:
| Year 1 | 5,500 units |
| Year 2 | 6,250 units |
| Year 3 | 7,000 units |
The European supplier of electric motors has quoted a price of $105 per unit, FOB ex-works, 1&2 with 5% price decreases per year for Year 2, and again for Year 3. Remember â the Year 3 price decrease is based off the Year 2 figure). The team assumes these price decreases are due to productivity improvements from higher volumes, the positive effects of learning at the supplier, and greater operating efficiencies. These prices have not been negotiated and the purchasing team believes that negotiation may lead to a lower unit price. If the new line of circulating pumps is successful, it is estimated that the life of the product cycle will be six years, reaching a peak of 8,000 units in Year 4, with a 10% reduction per year in volume after that as the product reaches the end of its life. It is estimated that the product will be completely phased out at the end of Year 6.
Shipping, handling, and receiving: Shipping, handling, and receiving costs at the buyer are estimated to be $15 per unit and should remain constant.
Tooling: The supplier has stated that it will cost $30,000 to fabricate the tooling and fixtures required to produce the electric motor. Rentex's policy is to assume ownership of tooling, so Rentex is responsible for the tooling costs. It's estimated that the tooling will have a usable life span of at least 6 years, with proper preventive maintenance (which the supplier has agreed to perform at no additional cost). The purchasing team plans to allocate the tooling costs evenly over the first three years.
Quality-related costs: The team has decided to include quality-related costs in its outsourcing calculations. During the investigation of the supplier, a team member collected data on the process that would likely produce the motors. The team estimates that the supplier's defect level, based on process measurement data, is 1,000 parts per million (ppm). Rentex's quality assurance department estimates that each supplier defect will cost Rentex $1,750 in direct nonconformance costs. Unfortunately, with quality problems there are always hidden costs that are difficult, if not impossible, to model.
Supplier capacity/safety stock: The team has concluded the supplier has available capacity to satisfy Rentex's current and near-term requirements for the motor. To mitigate supply chain risk, Rentex plans to hold one month's worth of the assembly as safety stock. The team assumes that this is a new cost each year.
Insourcing Costs
Rentex's cost engineering department has provided the following per unit cost estimates for internally manufacturing and assembling the motors during Year 1 of a three-year planning cycle:
| Direct labor | $19.75 | Cost of receiving components | $4.25 |
| Direct materials | $35.25 | Supplemental factory supplies | $2.15 |
| Transfer profit 3 | $21.75 |
Initial tooling and line modification costs: The start-up costs (including tooling) to modify existing production lines and equipment to accommodate production of the new motor will be $42,000, which will be spread out evenly over the first three years.
Depreciation expense: Depreciation expense on production equipment and tooling is considered a noncash item and is not included in the insourcing analysis.
Engineering design costs: Engineering costs to design, develop, and improve the production process will be $75,000 and will be spread evenly across the first three years of production.
Factory and corporate overhead: Overhead is allocated at 180% of direct labor costs.
Cost increases: In Years 2 and 3, management expects a 2% annual increase in direct material costs and a 3% increase in direct labor rates. (This increase is compounded so the increase in Year 3 costs is based off Year 2 cost figures).
Quality-related costs: The team estimates that Rentex's finished electric motor quality defects to be 2,500 ppm. Rentex's quality assurance department estimates that each defect costs the company $1,500 in nonconformance costs.
Preventive maintenance costs: Rentex's maintenance manager estimates that preventive maintenance of the production equipment required to produce the motors will cost $15,000 in Year 1, and will increase at the rate of 3% per year thereafter.
NOTES:
1. FOB (free on board) vessel means the supplier is responsible for transportation charges to the port in China.
2. Buyer is responsible for the cost and delivery of goods from the seller's location.
3. Transfer profit is the internal profit from selling to another unit in the company. This company views its units as profit centers, so profit must be included. Furthermore, the supplier has included profits in its quoted price.
Calculate the total cost per year for insourcing and outsourcing. Also calculate the cost per unit.
