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This discussion is focused on Electronic Testing Operation (ETO) and its competitive environment. ETO test electronic components. These components and supplied by its clients. Testing processing is becoming more complicated and need highly more expensive and less labor-intensive equipments. ETO’s existing cost system is very simple (Cooper, 1987). It contain only one cost center- the entire facility. All overhead is collected into a single cost pool, and the total overhead cost is divided by the total number of direct labor dollar consumed to give a single direct labor burden rate.
The two-stage diagram is used to calculate the 145% burden rate. It is important to draw this diagram when calculating because the process underlines most modern cost systems. The existing system was implemented due to the assumption that all products consume overhead and direct labor in the same proportion. All of the testing was labor intensive and undertaken on simple machines (Cooper, 1989). The inability of the existing system to capture the relationship between the consumption of labor and overhead for the different kinds of product can be used to illustrate demonstrate the subtle and not so subtle role that cost system play in the enactment of the chosen strategy of the firm.
ETO uses two techniques to improve its cost system. They include; increasing the number of cost centers, and changing the second-stage alloation base. These two methods are effectively independent. You will be asked to draw the two-stage diagram for the two-center system, and then fill in the numbers (Cooper, 1989). These are provided in exhibit 3 of the case. The two-version numbers are shown in exhibit TN-4b.
The product costs reported by the two-center systems for the five components listed in exhibit 4 can be calculated by: (i) multiplying the machine hours consumed by each product in the test room by $80.00 per hour. (ii) Multiplying the direct labor content of the products by 0.20, and (iii) adding the results to the labor cost. The three systems reports different costs for each product. It is therefore; only natural to query which system is more accurate (Cooper, 1987).
True product costs are usually unobservable for three reasons including:
i)There maybe no relationship between the consumption of inputs and the products produced.
ii)The cost of measurement maybe prohibitive. For instance, the wear on a cutting tool can be measured using a laser. Nevertheless, the cost of undertaking this measurement outweighs the benefit by far.
iii)The relationship between costs and the product maybe unobservable. For instance, repair and maintenance expenses emerge because products are run on a machine. The relationship between repair and maintenance expenses and certain pproducts cannot be observed, even though it is known that there is existence of a relationship.
Intuitively, the three-center system is the more accurate. Data provided in exhibit 5 of the case is used to determine the burden rate of the machine. The burden rate for the first year will be much higher than the Nth year due to start-up costs and depreciations (Cooper, 1989). Levels of product-cost accuracy can be depicted by a target. True product costs are represented by the bull’s eye. With most traditional cost systems, the degree of accuracy is somewhere on the fringe of the target. The system moves closer and closer to the true cost as it is refined to offer greater and greater accuracy.
Judgment and modeling approaches are used to determine the correct numbers of cost centers. Judgment may include performing a periodic reality check to determine if the current technique of collecting data and allocating costs at least makes intuitive sense (Cooper, 1989). Modeling can start by either moving slowly towards complexity until the optimum is found or by designating as many cost centers as possible and then deleting them. However, using the double-declining-balance depreciation method on the new machines creates problems on the new machines due to the fact depreciation expenses differ so dramatically from year to year.