Ten years ago our electric motor business was in real trouble. Low labor rates allowed the Eastern Bloc countries to sell standard motors at prices we were unable to match. We had become the high-cost producer in the industry. Consequently, we decided to change our strategy and become a specialty motor producer. Once we adopted our new strategy, we discovered that while our existing cost system was adequate for costing standard motors, it was giving us inaccurate information when we used it to cost specialty motors. Mr.
Karl-Heinz Lottes—Director of Business Operations, EMW SIEMENS CORPORATION Headquartered in Munich, Siemens AG, a producer of electrical and electronic products, was one of the world’s largest corporations. Revenues totaled 51 billion deutschmarks (DM) in 1987, with roughly half this amount representing sales outside of the Federal Republic of Germany. The Siemens organization was split into seven major groups and five corporate divisions. The largest group, Energy and Automation, accounted for 24 percent of total revenues.
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Low wattage alternating current (A/C) motors were produced at the Electric Motor Works (EMW), which was part of the Manufacturing Industries Division of the Energy and Automation Group. High wattage motors were produced at another facility. THE ELECTRIC MOTOR WORKS Located in the small town of Bad Neustadt, the original Siemens EMW plant was built in 1939 to manufacture refrigerator motors for “Volkskuhlschraenke” (people’s refrigerators). Less than a year later, Mr. Siemens decided to halt the production of refrigerator motors and began to produce electric motors for other applications.
At the end of World War II, the Bad Neustadt plant was the only Siemens factory in West Germany capable of producing electric motors. All the other Siemens production facilities had been completely destroyed or seized by Eastern Bloc countries. After an aggressive rebuilding program, Bad Neudstadt emerged as the firm’s primary producer of electric motors. Through the 1970s, WMW produced about 200 different types of standard motors, at a total annual volume of about 230,000 motors. Standard motors accounted for 80 percent of sales volume—the remaining 20 percent were customized motors.
The production process was characterized by relatively long runs of a single type of motor. Because identical motors were used by a wide range of customers, standard motors were inventoried and shipped as orders were received. Production of standard A/C motors was extremely competitive. The key to success was to reduce costs so that the firm could price aggressively while making a profit. Despite a major expansion and automation program begun in 1974, by the early 1980s it had become obvious that the lower labor rates of the Eastern Bloc competitors gave them an insurmountable cost advantage.
CHANGE IN STRATEGY An extensive study of EMW’s production capabilities and the market for electric motors indicated that EMW was in a position to become a profitable producer of low-volume, customized A/C motors. To help implement this strategy, the Bad Neustadt plant was enlarged and dedicated to the manufacture of A/C motors with power ratings ranging from 0. 06 to 18. 5 kilowatts. These motors supported a number of applications including automation engineering, machine tools, plastic processing, and paper and printing machines.
For the new strategy to succeed, EMW needed to be able to manufacture efficiently a large variety of motors in small production runs. Between 1985 and 1988, EMW spent DM50 million a year to replace almost every machine on the shop floor and thereby create a production environment that could support its new strategy. By 1987, the production process was highly automated with numerically controlled machines, flexible machining centers, and robotically fed production processes used throughout the factory.
Large-volume common components were manufactured using the appropriate automated equipment, whereas very low-volume components might be made in manual processes. Where possible, flexible manufacturing was used to produce small-volume specialty components. While a normal annual production volume for common components might be 100,000 units, a single component could have up to 10,000 custom variations that might have to be produced one at a time. To design a custom motor, modifications were made to a standard motor design. The process involved determining where standard components would not be used.
These standard components were replaced by custom components that provided the functionality required by the customer. By 1987, the EMW strategy seemed to be successful. Of a total of 65,625 orders accepted, 90 percent were for custom motors. A total of 630,000 motors was produced (see Exhibit 1). Including all customized variations, Siemens EMW produced about 10,000 unique products that collectively required 30,000 different special components. Exhibit 1 Distribution of Orders Accepted for Production in 1987 Number of Motors3% 630,0009%>99 motors44% 52,80014%20-99 motors31% 157,50026%5-19 motors13% 75,60048%2-4 motors7% 31,5001 motor5% Number of Orders65,625 CHANGE IN THE CALCULATION OF PRODUCT COSTS Beginning in 1926, EMW had used a product costing system. This system assigned material and labor costs directly to the products and divided overhead costs into three categories: material related, production related, and support related. Material-related overhead included costs associated with material acquisition, and was allocated to products based on their direct materials cost.
Production-related overhead was directly traced into production cost centers, and was allocated to products using either direct labor-hours or machine-hours, but not both. For more manually intensive machine classes, direct labor-hours was used; for machines whose operation required few direct labor-hours, machine-hours was used. In 1987, EMW used 600 cost centers, one per machine type. Support-related overhead was allocated to products based on the sum of direct material and direct labor costs, material overhead, and production overhead.
The breakdown of each cost category as a percent of total costs was as follows: Percent of Total CostsBurden Rate Direct material29% Direct labor10 Material overhead25. 7% of material cost Production overhead33(600 different rates) Support-related overhead2635. 4% of manufacturing cost Two years after the change in strategy, problems with the traditional cost system became apparent. Management’s concern with the traditional cost system was its inability to capture the relation between the increased support costs and the change in product mix.
Under the traditional system, support costs were allocated to each motor based on its consumption of direct materials, direct labor, and either direct labor-hours or machine-hours. Management felt that most support costs were more closely related to the number of orders received or the number of internal factory orders for the customized components required by a specific model of motor. As shown in Exhibit 1, 74 percent of the orders accepted for production by EMW after the change in strategy were for fewer than five motors.
This simultaneous increase in the number of orders and reduction in the average number of motors per order increased the load on the production support departments. An analysis of the way work was generated by orders in the shipping and handling, order processing, technical analysis of incoming orders, billing, and product costing departments indicated that the same resources were required to process an order for one motor as an order for 100 units of that motor. The increase in the number of products with special options similarly caused the production scheduling, purchasing, packaging, product development, and design departments to expand.
An analysis of the way work was generated by special components in these departments indicated that it was not the total number of special components (i. e. , unique part numbers) in each motor design that determined the work load. For example, processing an order of 50 units of a custom motor with a design requiring 10 special components per unit generated the same amount of work as processing an order of only one unit of a custom motor also requiring 10 special components. For either order, 10 special components had to be processed. In 1987, EMW processed 65,625 customer orders.
The motors produced to fill these orders required that 325,000 different batches of special components be processed. In total, over a million units of special components were produced in 1987. An extensive study was undertaken to identify the support costs that management believed were driven by processing customer orders and processing internal factory orders for special components. Part of each of the following departments’ costs was allocated to two new overhead cost pools: ?Costs Related to Customer Order Processing Billing Order Receiving Product Costing and Bidding Shipping Costs Related to Processing Orders for Special Components Inventory Handling Product Costing and Bidding Product Development Purchasing Receiving Scheduling and Production Control Technical Analysis of Incoming Orders Once these costs were identified they were removed from the former support-related cost pool and assigned to two new cost pools. Exhibit 2 illustrates the formation of the two process-oriented cost pools for 1987. The first column presents total costs grouped by traditional costing system definitions. To move to process-oriented costing (PROKASTA ), DM6. 3 million as removed from the engineering costs and DM27 million from administrative costs; these DM33. 3 million of costs were then assigned to the new cost pools, DM13. 8 million to order-processing costs and DM19. 5 million to special components costs. Exhibit 2 1987 Reconciliation Traditional Cost System to Process-Oriented Systems (thousands) TraditionalTransferredProcess-Oriented MaterialDM105,000DM105,000 Material overhead6,0006,000 Labor36,00036,000 Labor or machine overhead120,000120,000 Manufacturing cost267,000(74%)*267,000(74%) Engineering costs12,000DM(6,300)5,700 Tooling costs22,500022,500
Administrative costs60,000(27,000)33,000 Support-related cost*94,500(26%)(33,300)(9%)61,200(17%) Customer order-processing13,80013,800 Special components processing19,50019,500 Total costDM361,500DM 0DM361,500 * Percent of total cost. With process-oriented costing, the cost of the base motor from which the customized product was derived and the cost of each custom component was calculated using the traditional cost system but with the new, smaller support-related cost pool (see Exhibit 3). The two new cost elements (customer order and special component order processing) were then added.
EFFECT OF THE MODIFIED COST SYSTEM In 1987, EMW received close to DM1 billion in orders, but accepted only DM450 million. Production volume ran at 115 percent of rated capacity. The product cost information generated by the redesigned system played an integral role in helping EMW managers determine which orders were profitable and should be accepted. Mr. Karl-Heinz Lottes, Director of Business Operations, commented on the role of the new cost system in helping to establish the new strategy: Without the redesigned system, our new strategy would have failed.
With the information generated by the process-oriented cost system we can identify those orders we want to accept. While some orders we lose to competitors, most we turn down because they are not profitable. Anyone who wants to understand the importance of the PROKASTA system simply has to look at the costs of some typical orders under the traditional system and PROKASTA. Exhibit 3 Unit Costs for Five Motor Models (DM) Modified Cost System ABCDE Cost of Base Motor (before assignments from two new cost pools) 304. 0 304. 0 304. 0 304. 0 304. 0
Cost of All Special Components* (before assignments from two new cost pools) 39. 6 79. 2 118. 8 198. 0 396. 0 No. of Different Types of Special Components per Motor123510 AssumptionsBase Motor CostSpecial Components Cost Materials9012. 0 Material overhead50. 7 Direct labor354. 5 Manufacturing overhead11715. 0 Manufacturing cost24732. 2 Support-related overhead (modified)577. 4 Unit cost (before assignments from two new cost pools)30439. 6 * For illustrative purposes, each different special component is assumed to cost DM39. 6 per unit. Questions: 1. Consider the five illustrative motor models in Exhibit 3.
Under the former (traditional) system, what would the full cost of fulfilling an order for one unit of each model have been? What would have been the average cost per unit of each model if 10 units were ordered? 20 units? 100 units? What do your results suggest about the shortcomings of the old system with the new strategy? 2. Repeat the Question 1 calculations using the modified (PROKASTA) system. Have the shortcomings in the traditional system been addressed? 3. How significant are the differences in the average cost per unit between the modified system and the traditional system? Respond by examining the ratio of modified to traditional cost for each of the twenty model-type/order-quantity combinations. ) 4. Siemens’s former cost system had 602 cost pools; the modified system added only two additional pools, through which a relatively small portion of overhead (DM33. 3 million out of DM220. 5 million total overhead) was assigned. Explain why such an apparently modest elaboration of an already complex cost system significantly changed the costs of certain model/quantity combinations. 5. Suggest how Siemens could further improve its system while at the same time reducing the total number of cost pools well below 604.