The German manufacturing giant Siemens currently markets the largest range of electric motors in the world under its SIMOTICS brand.1This success was ensured by a transformation of Siemens Electric Motor Works (SEMW) in the early 1980s when management decided to move to a specialised customised electric motor manufacturer. This strategic reorientation transformed the manufacturing process and lead to continued profitability in a competitive environment.
One of the key factors in this success was a change in the costing system. Activity based elements were introduced which identified the number of customer orders and number of types of specialised components as key cost drivers. SEMW’s transformation is a classic case study in process costing.2 2. Strategic reorientation
2.1 COMPetition: the Need for Change3
SEMW commenced in 1937 in Bad Neustadt in the western German state of Bavaria. Most of Siemens’ electric motor factories were destroyed in the Second World War or fell under the control of Eastern Bloc countries after the war. Despite major expansion and automation in the 1970s, Siemens was struggling to compete in the production of standard A/C (alternating current) motors. Characterised by long runs of single types of motors which were inventoried and shipped on receipt of orders to a wide range of customers, marginswere low leaving SEMW unable to compete on price. By the 1980s labour costs were a major competitive advantage for Eastern Bloc manufacturers.
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Due to strong economic recovery in West Germany during the late 1950s and the 1960s, input costs, includingwages, increased. The Eastern European post-war experience had been very different, with wages and salaries, and standard of living, falling well behind that of West Germany. In this environment, SEMW’s managers saw that they needed to reduce costs.SEMW considered its options, and management decided to transform the operation into a specialised customised electric motor manufacturer. 2.2 SEMW’s move to a specialist customised motor manufacturer4 SEMW refocused their operations toward low-volume, customised A/C motors. Due to the higher margins compared to standard A/C motors, the customised A/C motors lead to increased profitability.In order to cater for a wider range of applications, SEMW produced a wide range of customised motors with power ratings from 0.06 to 18.5 kilowatts.
This change in strategy required a transformation of SEMW’s production environment. In order to produce a much wider variety of motor types in small runs required, Siemens invested DM50 million each year from 1985 to 1988 to retool, replacing the majority of machines. This strategic reorientation had proved itself by 1987. A total of 630,000 motors were sold with 10,000 different types of motors. Of the 65,625 orders, 90% were for custom motors. In order to better understand the cost structures of the new production environment, a process-oriented cost system was introduced by management. The new cost system helped management decide which custom orders to take by providing more accurate information on which products were cost effective. Despite running production at 115% of rated capacity, SEMW only accepted DM450 million of the DM1 billion in orders received.
2.3Transformation of the manufacturing process5
SEMW needed to come up with ways to reduce costsin the production of custom motors. This affected the manufacture process due to a higher proportion of low-volume components being required for production compared to standard motors. Customised motors were produced by making modifications in the base motors used in standard motor production. Each custom motor was modified using a range of custom components to meet the specific requirements for low volume orders. The strategy SEMW implemented was to increase automation of component manufacturing, allowing special components to be produced as required.
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In 1987, a total of 325,000 production orders and requisitions were prepared for special components. High volume components were manufactured using highly automated processes, while very low volume parts were sometimes made by hand. In addition, flexible manufacturing was utilised, with some components having up to 10,000 custom variations.This reduced costs associated with holding components in inventory, including handling and storage costs as well as the opportunity cost of unused inventory.
2.4 Inadequacies of the ‘TRAditional’ costing system6
SEMW has employed a costing system since 1926. In the traditional cost system, material and labour cost was assigned directly to the products. Production related overheads were allocated to products using direct labour hours or machine hours as the allocation base. This lead to the use of 600 different cost pools, one for each machine class. Support related overheads were allocated based on the total pre-support related manufacturing costs.
This treatment of support related overheads was unable to adequately capture the relationship between increased support costs and the change in product mix.The result was that high-volume, standardised products being overcosted and subsidising a subsequently under costed, low-volume, relatively complex products in SEMW’s customised motors. This in turn led to inaccurate unit cost and sub-optimal product-line pricing decisions.
3.THE Introduction of PROCESS costing
3.1 A new costing system for a new process7
By 1987, 74% of orders received by SEMW were for less than five motors.The move to smaller orders of highly customised motors led to increase in the number of orders, each of which had roughly similar support related costs regardless of how many motors in an order. Actual costs related to order processing showed that same amount of resources was required for orders of one custom motor or 100 standard motors. Another key cost driver for support related overheads was the number of types of specialised components in each customised motor. This was because each special component was manufactured on an as required basis.
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Therefore, a new process oriented costing system called PROKASTA was applied to the company, in which two new overhead costs are identified and separated out from support-related cost: order-processing cost and special component costs.8 3.2 Order processing and special components handling under the new system9 Under the PROKASTA system, support related overheads were restructured to create two new costs pools for order processing and support costs related to special components.
In 1987, these two new activity based cost pools accounted for 9% of total costs, out of a total support related costs of 26%, resulting in the transfer of DM43.3 million in costs from engineering related support costs and administrative costs. The remaining support related costs still being allocated under the traditional system (representing 17% of total costs in 1987) combined with the pre-support costs to represent the pre-PROKASTA costs.10 Order processing costs were allocated based on the number of orders accepted, which was 65,625 in 1987, and the cost pool consisted of:
Product Costing and Bidding
The rate per order is calculated using the following formula: 1.
Support costs related to special components was driven by the number of different types of special components used in each motor, and included the following costs:
Technical Examination of Incoming Orders
Scheduling and Production Control
Product Costing and Bidding
Each production order and requisition was able to list the special component by stock number and the quantities of each number of stocks required. In 1987, the Production orders and requisitions were prepared 325,000 times to call special components from inventory or initiate special component production. The special component overhead rate is calculated by using formula blow:
3.3Comparison of The ‘new system’ with the ‘traditional system’12 Total costs for each order are an accumulation of the pre-PROKASTA costs and the two new cost pools for support related costs. Hence, total cost of each order are calculated using the following formula: 3.
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Table 2below shows the costs for five orders for customised motors under the new, process oriented costing system. Using the rates per unit derived in Table 1, following formulas are applied to determine the per order costs for the new cost pools, which are added to the pre-PROKASTA costs:13 4.
In old system, only the part of support related overhead in special components part will change according to the number of different types of special components, with the part of support related overhead in base motor part will remain constant. Therefore, we can derive total SROH by following formula:
7. After original support related overhead cost has been derived, the following formula is applied to calculate the rate:
8. Table 4shows the costs under the traditional system of the same five orders in in Table 2.
TABLE 4: Comparison of costs for orders in Table 2 using the traditional system
Siemens Electric Motor Works’ strategic reorientation in the early 1980s toward production of custom electric motors is a classic case study in process costing. Broadly, it demonstrated the importance of appropriate costing methodology in ensuring managers are using accurate information to make production decisions. More specifically, it shows how activity based costing can be used to capture support related overhead costs where these are a significant component of the overall costs, as is the case is customised production models. The continued success of Siemens electric motor manufacturing operations is in no small part due to the importance SEMW’s management put on using the right costing system.
1. Why would any customer, let alone large advertising agencies and departmental stores, go to Colorscope rather than go to large printers listed in Exhibit 3?
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Before desktop publishing became popular, Colorscope had a competitive advantage through its expensive proprietary computer equipment that could produce complicated print special effects. Colorscope had also been able to build strong relationships with valuable customers through the years and had a good reputation for providing high quality work in its field.
Another reason why Colorscope could compete with the large printers was the high fragmentation of the pre-press industry. This was due to the fact that most pre-press companies focused on just a few print products (e.g. catalogs, newspapers or coupons) and had strong specialized expertise in these. Because of that, Colorscope could provide higher quality than the large printers in the fields where it had specialized. Before the dawn of desktop publishing, which led to commoditization of the services, competition was more based on quality than on price.
As a small agency, it is also probable that Colorscope could be more flexible in meeting specific demand and provide more tailored services to the few customers it served, compared to the large printers which would have a bigger and more bureaucratic organization.
3. What you have done above is a “full-cost” analysis. This is in contrast to a “direct-cost” analysis that ignores overhead costs. Is full cost the right metric for job profitability and customer profitability? What assumptions are we making about the variability of overhead costs when we do a “full-cost” analysis?
By allocating the overhead costs to jobs and customers there is an implicit assumption that these are variable with the cost driver. In reality, some of the overhead costs are fixed, at least in the short run.
One benefit of using full cost is that the price charged for jobs needs to recover all costs…