Chapter 11, Problem 26P

Moss Manufacturing produces several types of bolts. The products are produced in batches according to customer order. Although there are a variety of bolts, they can be grouped into three product families. The number of units sold is the same for each family. The selling prices for the three families range from $0.50 to $0.80 per unit. Because the product families are used in different kinds of products, customers also can be grouped into three categories, corresponding to the product family they purchase. Historically, the costs of order entry, processing, and handling were expensed and not traced to individual products. These costs are not trivial and totaled $6,300,000 for the most recent year. Furthermore, these costs had been increasing over time. Recently, the company had begun to emphasize a cost reduction strategy; however, any cost reduction decisions had to contribute to the creation of a competitive advantage.

Because of the magnitude and growth of order-filling costs, management decided to explore the causes of these costs. They discovered that order-filling costs were driven by the number of customer orders processed. Further investigation revealed the following cost behavior:

Step-fixed cost component: $70,000 per step; 2,000 orders define a step*

Variable cost component: $28 per order

*Moss currently has sufficient steps to process 100,000 orders.

The expected customer orders for the year total 140,000. The expected usage of the order-filling activity and the average size of an order by product family are as follows:

As a result of the cost behavior analysis, the marketing manager recommended the imposition of a charge per customer order. The president of the company concurred. The charge was implemented by adding the cost per order to the price of each order (computed using the projected ordering costs and expected orders). This ordering cost was then reduced as the size of the order increased and eliminated as the order size reached 2,000 units. (The marketing manager indicated that any penalties imposed for orders greater than this size would lose sales from some of the smaller customers.) Within a short period of communicating this new price information to customers, the average order size for all three product families increased to 2,000 units.

Required:

1. 1. Moss traditionally has expensed order-filling costs (following GAAP guidelines). Under this approach, how much cost is assigned to customers? Do you agree with this practice? Explain.
2. 2. Consider the following claim: by expensing the order-filling costs, all products were undercosted; furthermore, products ordered in small batches are significantly undercosted. Explain, with supporting computations where possible. Explain how this analysis also reveals the costs of various customer categories.
3. 3. Calculate the reduction in order-filling costs produced by the change in pricing strategy. (Assume that resource spending is reduced as much as possible and that the total units sold remain unchanged.) Explain how exploiting customer linkages produced this cost reduction. Moss also noticed that other activity costs, such as those for setups, scheduling, and materials handling costs, were reduced significantly as a result of this new policy. Explain this outcome, and discuss its implications.
4. 4. Suppose that one of the customers complains about the new pricing policy. This buyer is a lean, JIT firm that relies on small, frequent orders. In fact, this customer accounted for 30 percent of the Family A orders. How should Moss deal with this customer?
5. 5. One of Moss’s goals is to reduce costs so that a competitive advantage might be created. Describe how the management of Moss might use this outcome to help create a competitive advantage.