Tijuana Bronze Machining - Analysis of Product Costing Methods

DATE: JUNE 5, 2012

FROM: MIKE KOWALSKI, JOHN TURNER, HUSS SADRI, AND TRAVIS BRUNIC

TO: MR. HERB ALPERT, PRESIDENT OF TIJUANA BRONZE MACHINING

SUBJECT: ANALYSIS OF PRODUCT COSTING METHODS

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Introduction

Tijuana Bronze Machining (TBM) has become known for manufacturing quality components for water purification systems. The company has introduced three interrelated product lines - valves, pumps, and flow controllers - that utilize similar manufacturing systems. Recently Tijuana Bronze has been rocked by price cuts in the pump market and the management team find themselves wondering whether their competitors follow unsound business practices or whether they themselves are missing something. In contrast, Tijuana Bronze raised prices of their flow controllers by 12.5% and saw no effect on sales. Again, president Herb Alpert questioned why there were no competitors entering the market following this increase. These seemingly disparate problems may have a shared root cause.

Alpert and his team felt these questions required a new approach to cost accounting. TBM was currently using a traditional approach - tracking direct material and labor and applying overhead based on per-unit labor hours. TBM's accountant Mary Ford had suggested a hybrid system that used an activity based costing method for material handling and receiving but maintained the traditional approach for the remaining overhead costs. The group also discussed moving to a complete activity based costing approach for all overhead. These different approaches result very different costs for TBM products and this may be the source of the different pricing strategies used by competitors. Choosing which system best represents the true costs of the various product lines will greatly impact the strategies of Tijuana Bronze, and hence we analyze these costing methods further.

Analysis

Traditional Cost Accounting

In an effort to solve the problems that TBM is facing, our data analysis will investigate the provided accounting information and the cost and profitability of each product line.

The current cost structure used by TBM shown in Exhibit 2 is calculated based on direct and indirect costs and assumptions of production activity. Each unit of a product is charged for material cost based on the prices that TBM pays for components, and for labor costs based on standard run labor times priced at $16 per hour. Our first analysis determined each product cost per unit, starting with determining the non-unit overhead costs (including set-up labor) as shown in Fig 1. Next an overhead rate was generated per production-run labor cost (see above calculation method used) and allocated based on the production-run labor cost per product. The results of the calculations are shown for each product in Table 1.

We also determined the current contribution margins (CM = sale price - variable cost) for each of the three products (Table 2). As per Mary Ford's conversation, "the only short-run variable cost is direct material", hence the contribution margins listed above. Using this method flow controllers showed the highest contribution margin with $75.07. However, the contribution margin should not disregard the labor or overhead costs because sales representative might incorrectly target consumers willing to pay prices that barely exceed marginal costs and would not be sufficient to cover the remaining period costs. TBM currently tries to maintain a 35% gross margin over standard unit costs that include labor and overhead.

Revised Cost Accounting (Mary Ford's Method)

In order to determine the revised product unit cost mentioned by Mary Ford using the information in Exhibit 2, we used the calculations shown above for each product. The calculations determined the material related overhead costs (Pool 1) and allocated that to each product line based on the cost of materials. Following this, the remaining overhead (Pool 2) was allocated to each product based on the number of machine hours per unit.

The results of the calculations are shown in Table 3. The comparison between the standard product costs and the revised standard product costs (Table 1 vs. Table 3) give some indication as to why competitors are willing to lower prices, particularly in the pump market. The revised standard cost for pumps is more than $4.00 below the current costing method raising the current gross margin from 22% to 27%.

Activity-Based Costing Method

Based on information from Exhibits 2 and 3, the product costs for valves, pumps and flow controllers were determined using the ABC approach. For this method, overhead was allocated to products based on the percent of total transactions that each product consumed (Exhibit 3).

Table 4 shows that flow controllers consume a large majority of the transactions, and the resulting overhead allocation leads to a much higher per-unit cost than valves and pumps. This is only seen in the ABC method, suggesting that this method gives a more accurate representation of the true costs involved in the manufacturing process.

The differing overhead allocations that result from the three costing methods (standard, revised, ABC) greatly affect the gross margins as shown in Table 5. Product line profitability changes most significantly for flow controllers under ABC, dropping from the highest gross margin product to lowest. The ABC method best illustrates the complexity of the current JIT flow controller manufacturing process (more components, more receipts/handling/shipments), by shifting the proportional overhead costs onto this product line, thus it is our recommended costing system moving forward.

Using ABC to Re-Evaluate JIT Purchasing Policy for Flow Controllers

According to Exhibit 2, production of flow controllers requires 10 components for